What is a 412(i) Plan?
Small businesses seeking to offer their employees retirement benefits may find 412(i) plans appealing. What is a 412(i) plan? It’s a type of retirement plan based around annuities, making it different from the likes of traditional or simple retirement plans. These plans are advantageous to both employees and employers when structured appropriately. But, they come with important stipulations that make them very unique retirement accounts.
If you’re offered a 412(i) plan by your employer, it’s important to understand the nuances of how these programs operate. If you’re unfamiliar with annuities, you’ll want to research them thoroughly, as well. While a 412(i) plan is a far cry from a conventional retirement account like a 401(k) or an IRA, it can be an advantageous way to set yourself up for a fixed income in your retired years.
An Overview of 412(i) Plans
As a type of defined-benefit pension plan, a 412(i) isn’t a traditional investment account. Instead, account holders buy into annuities and life insurance that pays out a fixed income in the future. Due to their structure, employer-sponsored 412(i) plans are actually funded by insurance companies. They’re sometimes called “fully insured defined benefit plans.”
Due to the potential for abuse (see below), 51% of a 412(i) plan must comprise annuities that directly benefit the plan participant. Only 49% of the plan’s contributions can go toward life insurance.
Paying installment contributions into the 412(i) plan qualifies the employee to receive fixed annuity payments in the future. The plan is funded to a specific age and begins to pay out after that age, regardless of whether the person is still working. Like all other retirement accounts, required minimum distributions begin at age 70½.
Annuity contributions are pre-tax, which benefits both companies and employees. Moreover, companies receive tax deductions based on contributions. That said, there are large premiums to consider and employers need to shoulder them. This can make 412(i) plans prohibitive for small companies that struggle to maintain cash flow or profit.
What Are Annuities?
The most unique part about 412(i) plans is that they’re centered on annuities. Annuities are contracts that pay a fixed return once funded adequately. Funding takes place during the accumulation phase; payouts happen in the annuitization phase. Annuities can pay out for a fixed period of time or through the end of a person’s life, depending on the contract.
There are different types of annuities, including fixed, variable, immediate, deferred and more. Each type comes with different risk and reward, though these variables correlate. Regardless of the type of annuity, they’re generally seen as a hedge against outliving your retirement savings. Many retirees hold annuities to complement Social Security payments as a fixed source of income.
Annuities also come with a cash surrender period. This means the contract holder can’t withdraw money without paying a fee to do so. These fees are typically quite high. Don’t confuse this with the cash surrender value of the annuity, which is the sum of contributions and accumulated earnings, minus prior withdrawals and outstanding loans.
Who Benefits From 412(i) Plans?
412(i) plans benefit a broad range of groups. Small businesses and sole proprietors with stable cash flows can offer annuities as a way to create stability for employees in retirement.
The biggest benefactors of 412(i) plans and annuities are those with a shorter time horizon left before retirement. They can’t afford to shoulder the risk of volatility that comes with investing in securities. Instead, they turn to annuities to ensure they have a fixed income stream.
There can also be significant value in cashing out an annuity and rolling the lump sum into an IRA. Not only does this allow it to continue compounding, it can qualify a surviving spouse for those funds. This is typically a strategy used by individuals when estate planning.
Advantages and Disadvantages
Let’s talk about the biggest benefit of a 412(i) first: fully guaranteed retirement benefits. This is something simply not possible through a 401(k), 503(b), Roth IRA or even a SEP account. Invested accounts are subject to loss depending on market conditions. In contrast, annuities offer guaranteed, fixed payments. For this reason alone, 412(i) plans are highly desirable—especially by those with little-to-no risk tolerance.
That guarantee comes with a significant downside, however. Annuity contracts typically appreciate at a much lower rate than traditional securities. That means your compound annual growth rate (CAGR) on annuities might top 4%, while the market returns figures double or even triple that. The return on annuities is akin to bonds.
The biggest disadvantage of 412(i) plans is that they’re prone to abuse—and in fact, the IRS has begun cracking down on poorly-run 412(i) schemes. For example, plan administrators may set the cash surrender value significantly lower than the premiums paid, disincentivizing that option. Instead, the IRS mandates that buyouts must occur at fair market values. In a 2017 survey of 412(i) plans, the IRS found noncompliance in more than half.
Is a 412(i) Plan Worth It?
What is a 412(i) plan? While not as common as other traditional and simple retirement plans, a 412(i) plan is a useful tool for creating fixed income in your retirement years. Structured accordingly, it allows you to take advantage of annuities and the certainty that comes with them. Or, you may choose to roll your 412(i) into an IRA for a new set of benefits entirely.
Either way, it’s importatn to prepare yourseelf for retirement as early as possible. To learn more, sign up for the Wealthy Retirement e-letter below.
It’s important to remember that, at the end of the day, a 412(i) plan is a retirement vehicle. It’s worth taking advantage of as you look ahead to creating a comfortable retirement—one where you’re not in any danger of outliving your investments.