IRC Section 412(e)(3) “Guarantees” Defined Benefit Pensions

An income solution using fixed life and annuity contracts

By Russell E. Towers, JD, CLU, ChFC

Mr. Towers is vice-president, business and estate planning, with Brokers’ Service marketing Group, Providence, RI. He can be reached at

IRC Section 412(e)(3) provides a great opportunity for business owners to create a “fully insured” defined benefit plan with the largest possible deductions allowed by law. These plans are well suited for business owners and professionals who have few employees and a relatively short period of time until retirement. All eligible employees must be covered under the plan. The maximum annual retirement benefit is indexed at $200,000 for 2012 ($16,666 per month).

The maximum earned income that may be taken into account for purposes of determining retirement benefits is indexed at $250,000 for 2012.
Generally, a defined benefit plan is a promise of future benefits where an actuary determines the required annual contribution with no flexibility in funding. A 412(e)(3) plan differs from a regular defined benefit plan in a number of ways. The accrued benefit is the cash value of guaranteed contracts and no enrolled actuary is needed to certify the annual contribution. Plan investments must be all fixed annuity and fixed life insurance products.


Plan benefits are guaranteed by insurance and annuity contracts issued by life insurance companies:

  •  Premiums must be paid when due.
  •  The guaranteed annuity purchase rate factors are the target for monthly benefits.
  •  Only the guaranteed cash value of the life insurance policies may be projected.
  •  The guaranteed annuity interest factor must be used as the pre-retirement interest rate assumption.
  •  Life insurance dividends for whole life or current interest rate for universal life must be used to reduce the contribution for the following year.
  •  The annuity interest paid in excess of the guaranteed rate must be used to reduce the contribution for the following year.
  •  No loans are allowed on the contracts.


This results in much higher early year plan contributions (deductible) than a regular defined benefit plan. The account balance exactly matches the amount needed to pre-fund the benefit. Contributions (deductions) will decrease in future years if current product crediting rates exceed the guaranteed rates.
Advantages Of 412(E)(3) Plan

  •  Fixed annuity and life insurance contracts guarantee the defined benefit.
  •  Participant has exact understanding of accrued benefit.
  •  Generally, no reversion of excess plan assets is possible.
  •  No enrolled actuary is needed, so administrative fees are smaller (IRC Section 45E allows a partial tax credit for fees incurred during the first three plan years).
  •  Much larger tax deductions in early years of plan.
  •  Defined contribution plan limits are only $50,000 for profit sharing or SEP type of plans.
  •  Life insurance death benefit in excess of cash value is income tax free to plan beneficiary.
  •  Small “economic benefit” on the “pure” life insurance amount based on Table 2001 rates is reported as income to participant and gives participant a cost basis in the policy.
  •  Plan may be funded 100% funded with fixed annuity products
  •  Alternatively, based on the formula allowed in Rev. Rul. 74-307, the plan may be funded with a 50-50 annual contribution to fixed annuities and fixed life insurance products. The life insurance death benefit under this 50-50 formula would typically be much greater than the regular maximum life insurance death benefit which is based on 100 times the maximum monthly defined benefit of $16,666 ($1,666,666 face amount).

Planning considerations

The “pass through” nature of a professional “S” Corp, partnership, or limited liability company (LLC) could provide tax deductions in a personal tax bracket as high as 35%.

Only “earned income” compensation may be taken into account for purposes of qualified plan contributions and benefits. The “pass through” nature of a professional “S” Corp, partnership, or limited liability company (LLC) could provide tax deductions in a personal tax bracket as high as 35%. Keep in mind that Schedule K-1 profit (“passive income”) for “S” corporation owners may not be taken into account for purposes of qualified plan contributions or benefits. Only “earned income” (W-2 compensation) may be considered for determining qualified plan amounts for “S” corporations (Durando v. USA, 70 F. 3d 548 (9th Cir. 1995)).

However, partners and LLC members may use all their Form 1065 Schedule K-1 partnership net profit for purposes of determining qualified plan contributions and benefits as long as the net profit is classified as “earned income” in the form of “guaranteed payments”. If these professionals already have a profit sharing or SEP plan, these plans can be frozen or terminated and rolled to IRA’s before the new 412(e)(3) plan is implemented.

This very same IRA can be utilized 15 years later as a direct rollover account for the 412(e)(3) annuity values plus any surrendered cash value of life insurance owned by the 412(e)(3) plan if the participant reaches the age of retirement and decides not to take annuitized defined benefit payments. Be aware of the full funding limitation under the GATT rules (Retirement Protection Act of 1994) for lump sum distributions and rollovers. The GATT limit is not based on the carrier guaranteed rates … it is based on the “weighted average interest rate” at the time of the distribution. Because of this rate differential, most fully funded 412(e)(3) plans will be over-funded for GATT purposes. The lump sum distribution and termination of an over-funded plan may create taxable income to the employer, as well as a 50% excise tax on the amount of over-funding. It is important to note that this distribution limit applies only to lump sum distributions … NOT to the annuitization of benefit payments.

Naturally, the life insurance in the 412(e)(3) plan cannot be transferred to the IRA (IRC Section 408(a)(3)) if the participant decides to keep the insurance in force after termination of the plan. However, the insurance policy ownership can be distributed from the plan trustee to the participant at retirement and then gifted by the participant to an irrevocable insurance trust to potentially be excluded from estate taxes at death. The policy’s fair market value minus the cumulative Table 2001 “economic benefit” cost basis would be taxable income to the participant. Then the participant would gift the policy ownership (gift of net policy value) to the irrevocable insurance trust subject to the 3 year rule of IRC Section 2035.
Case Example Of A One Person Business

Assume an owner of a “one person” business (incorporated or not) has $400,000 of earned income and desires a plan with guaranteed retirement income and a large current tax deduction. The chart below illustrates the maximum first year contribution to a Section 412(e)(3) plan from a competitive carrier which specializes in these defined benefit type of plans.
Maximum Deductible Contribution in First Year
to Section 412(e)(3) Plan

  1. Age    Annuity Only    Max Annuity Plus Life Insurance
  2. 40      $100,271         $108,782
  3. 45      $133,619         $150,482
  4. 50      $192,963         $227,525
  5. 55      $267,517         $339,065

Note: The contributions shown above are based on the maximum defined benefit of $200,000 in 2012.

These contributions assume the guaranteed annuity purchase rate, the guaranteed cash value of life insurance, and the guaranteed annuity accumulation rate of the competitive carrier. The values also assume that the business owner retires at age 62. In a 40% combined federal and state tax bracket, the tax savings are substantial.