For a small business owner whose business is prosperous and solid, who wants to max out his qualified plan funding, and who wants the benefits to be as secure as possible, few tools can match the advantages of a "fully insured" plan. Until a few years ago, fully insured plans were governed under Internal Revenue Code section 412(i), and were typically called "412(i) plans." The Pension Protection Act of 2006 moved these provisions to Code section 412(e)(3) with no other changes, but many practitioners still refer to these plans as 412(i) plans.
What is a fully insured plan? A fully insured plan is a defined benefit plan that is fully funded by life insurance, annuities or a combination of both. Since it is a type of defined benefit plan, a fully insured plan is subject to funding requirements and must provide a definitely determinable benefit to participants. A fully insured plan is also subject to the qualification requirements that apply to all qualified plans, such as participation, coverage, Section 415 limits, vesting, nondiscrimination, and so on. The plans are so named because they are based on an exception to the minimum funding requirements for defined benefit plans.
What are the advantages of a fully insured plan over a traditional defined benefit plan? A fully insured plan gives the business owner the opportunity to make the maximum deductible retirement contributions, provide for level funding and offer greater security to participants, since the benefits are guaranteed by the insurance company with whom the plan is funded. Fully insured plans are also relatively simple to administer, and are not subject to the full funding limitation. Finally, the benefits are easier to explain to participants, because the participant's accrued benefit is equal to the cash value of the contracts funding the account.
Are fully insured plans subject to the incidental benefit limits on life insurance in qualified plans? Yes. A fully insured plan may provide for the payment of "incidental" death benefits through life insurance in the same manner as any other defined benefit plan. The incidental benefit test is satisfied if (1) the cost of the benefit is less than 25 percent of the cost of all benefits provided under the plan (the 25 percent rule), (2) the insured death benefit is no more than 100 times the participant's expected monthly benefit under the plan, or (3) less than 50 percent of the employer contribution credited to each participant's account is used to purchase "ordinary life insurance."
What is the controversy that has surrounded fully insured plans? Some companies that marketed fully insured plans promoted funding that the Treasury Department viewed as abusive. For example, some companies designed the policy to result in very high deductible premiums, but used very low guaranteed rates. Many of these companies then suggested terminating the plan after just a few years, at which time the contracts were distributed to the plan participants (often consisting only of the business owner). Due to the low guaranteed rates, the contracts had little cash value, so the distribution resulted in minimal tax liability, and the policy's cash value then grew rapidly outside the plan. These policies were sometimes said to have "springing cash values." At that point, the owner was able to access the value through policy loans. In 2004, the Treasury Department issued regulations providing that the distributed policies must be valued at fair market value, including the cash value and all other rights other the policy. In 2005, the Internal Revenue Service provided safe harbor rules on how to calculate the fair market value of a policy.
As with any tool, the tendency of some companies to "push the envelope" could lead to intrusive restrictions for all. Some experts suggest the use of annuities for at least half of the funding of fully insured plans. More than 50 percent funding with life insurance is considered highly aggressive and not recommended, according to some commentators.
IRC Sec. 412(e)(3); Treas. Reg. §1.83-3(e); Rev. Proc. 2005-25, 2005-17 IRB 962.
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