defined benefit plan

Section 412(e)(3) Plan (Fully Insured Defined Benefit Plan)

What is a Section 412(e)(3) plan

A Section 412(e)(3) plan is a type of defined benefit pension plan. Like all defined benefit plans, a 412(e)(3) plan pays benefits to participants based on a formula set forth in the plan; a participant's compensation, age, and length of service may all be factored in. And like all defined benefit plans, a 412(e)(3) plan is generally funded solely by the sponsoring employer.

What differentiates a 412(e)(3) plan from other defined benefit plans is the way the plan is funded. While other defined benefit plans can be funded with a wide range of investment options, 412(e)(3) plans are funded exclusively with insurance and annuity contracts. For this reason, they're often referred to as "fully insured" defined benefit plans.

Section 412(e)(3) plans get their name from the section of the Internal Revenue Code (IRC) that defines them. IRC Section 412(e)(3) provides that defined benefit plans funded exclusively with the purchase of insurance and annuity contracts (and meeting certain other requirements) are not subject to the minimum funding provisions of IRC Section 412. These minimum funding provisions include required annual actuarial calculations and mandatory employer contributions to sustain the minimum-funding requirement; a penalty tax is imposed for failure to comply with the minimum funding provisions.

IRC Section 412 was amended by the Worker, Retiree, and Employer Recovery Act of 2008, and the provisions formerly found in IRC Section 412(i) are now found in IRC Section 412(e)(3).

412(e)(3)/412(i) plans have been around for some time. In recent years they received a great deal of press In part a result of some aggressive (and controversial) strategies involving these plans. In response, the Treasury Department and the IRS have issued guidance intended to curb perceived abuses. This guidance is discussed at the end of this article.

Any annuity and life insurance guarantees are subject to the claims-paying ability of the issuer/insurer.

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A 412(e)(3) plan should be considered whenever a defined benefit plan is appropriate. While almost any employer can set up a defined benefit plan for its employees, defined benefit plans may be most appealing to employers who have older, highly compensated owners and few non-owner employees, when the owners want to contribute as much as possible to their retirement on a tax-deferred basis, and when there is confidence that there will be adequate cash flow in future years. That's because defined benefit plans allow large deductions, and when an employer has few non-owner employees, most of the current contributions will generally be used to fund the benefits for older highly compensated principals.

412(e)(3) plans may be more appealing than other defined benefit plans to employers who are willing to trade potentially higher plan investment returns and flexibility for the generally lower-risk, more predictable, and easier-to-administer insurance and annuity contracts that fund 412(e)(3) plans. 412(e)(3) plans will also appeal to closely held employers who want to maximize tax-deductible contributions to a retirement plan in the early years of the plan. Like all defined benefit plans, employers must have the financial ability to support the plan on an ongoing basis; these plans are probably not appropriate for start-up companies.

412(e)(3) plan requirements

412(e)(3) plans must meet all six of the following IRC Section 412(e)(3) requirements:

  1. The plan must be a defined benefit plan funded exclusively by the purchase of annuity contracts or a combination of annuity contracts and insurance contracts. The contracts must be purchased from an insurance company licensed by a state or the District of Columbia to do business with the plan.
  2. The annuity and insurance contracts must provide for level annual (or more frequent) premium payments commencing on the date each individual begins participating in the plan and ending not later than the normal retirement age of that individual or, if earlier, the date the individual ceases participation in the plan.
  3. The benefits provided by the plan must consist entirely of the benefits provided by the annuity and insurance contracts, and the insurance company must guarantee the benefits.
  4. Premiums payable for the plan year and all prior plan years under the contracts must have been paid.
  5. No rights under the annuity or insurance contracts may be subject to a security interest at any time during the plan year.
  6. No policy loans may be outstanding at any time during the plan year.

For more information regarding these requirements, see IRC Section 412(e)(3) and accompanying regulations.

Using life insurance to fund the plan

If life insurance contracts are used to partially fund a 412(e)(3) plan, the amount of any life insurance coverage available is limited to an amount considered "incidental" to the purpose of the plan. This restriction is not limited to 412(i) plans, but applies to qualified plans in general. Nevertheless, this limitation is of particular importance when considering 412(i) plan funding.

Determining whether or not the amount of life insurance in a plan is incidental is complicated, and there are different ways to do it. For example, life insurance within a qualified pension plan is generally considered incidental if policy proceeds will provide a participant with a death benefit that is equal to or less than 100 times the participant's anticipated monthly normal retirement benefit. However, the incidental nature of life insurance can also be measured in terms of the percentage of plan contributions used to purchase the life insurance coverage. For additional guidance in this area, consult a retirement plan specialist.

412(i) plans do not need to utilize insurance contracts--they can be funded completely with annuity contracts.

Participant benefits under the plan

As with all defined benefit pension plans, the amount of each participant's future retirement benefit under a 412(e)(3) plan is determined by using a specific formula set forth in the plan. The formula generally bases each employee's benefit on his or her compensation, age, length of service with the employer, or some combination thereof. In the case of a 412(e)(3) plan, the underlying annuity and insurance contracts provide the funding mechanism for the benefits.

In addition to normal retirement benefits, 412(e)(3) plans commonly offer a death benefit. Where a death benefit is offered, the participant generally has the right to name his or her own beneficiary for the death benefit proceeds.


412(e)(3) plans are generally subject to the same rules that apply to all defined benefit pension plans (e.g., nondiscrimination, vesting, participation, reporting). The exception is that 412(e)(3) plans are not subject to the minimum funding requirements of IRC Section 412. Therefore, employers adopting a 412(e)(3) plan are not required to employ an actuary to calculate ongoing funding requirements. In effect, by funding the plan with annuity and insurance contracts, this function is shifted to the insurance company. Because employers sponsoring a 412(e)(3) plan do not need to hire an actuary, they do not need to file Schedule B, Actuarial Information, with IRS Form 5500.

412(e)(3) plans have the same advantages as other defined benefit pension plans. They allow higher deductible contribution levels than other types of employer-sponsored retirement plans, and they provide a guaranteed retirement benefit to participants. As with all qualified retirement plans, 412(e)(3) plan assets are protected from the claims of creditors.

412(e)(3) plans, however, offer some advantages over other defined benefit pension plans:

  • The minimum funding rules of IRC Section 412 do not apply. This means that an employer who adopts a 412(e)(3) plan does not have to employ an actuary to calculate funding requirements. Because of the manner in which it's funded, a 412(e)(3) plan generally can't be under funded or over funded.
  • The annuity and insurance contracts that fund 412(e)(3) plans provide a stable, predictable rate of return guaranteed by an insurance company, effectively shifting the plan's investment risk to the insurance company. (Guarantees are subject to the claims-paying ability of the issuing insurance company.)
  • 412(e)(3) plans will generally allow greater up-front tax-deductible contribution levels than other defined benefit pension plans.
  • 412(e)(3) plans are generally easier and less expensive (on an ongoing basis) to administer than other defined benefit pension plans.
  • 412(e)(3) plans can provide participants with a limited amount of life insurance.

412(e)(3) plans also share the disadvantages of other defined benefit plans. Plan funding is mandatory; an employer must make regular plan contributions (in the case of a 412(e)(3) plan these contributions would consist of premium payments) regardless of whether or not the business makes a profit. In addition, plan benefits aren't portable, and 412(e)(3) plans have to comply with most of the same reporting, participation, and nondiscrimination rules that other defined benefit plans are subject to.

In addition, 412(e)(3) plans have some disadvantages not shared by all defined benefit plans:

  • 412(e)(3) plans must be funded exclusively by annuity and insurance contracts. While this offers a stable, predictable rate of investment return, it also means that there is less flexibility and potential for investment growth than other plan investments might provide.
  • 412(e)(3) plans are not able to provide loans to participants.
  • Initial costs for a 412(e)(3) plan may be higher than initial costs for other defined benefit pension plans.

412(e)(3)/412(i) plans have been around for almost 30 years. In recent years, though, these plans have received an inordinate amount of attention, in part because volatile investment markets have sparked renewed interest in stable, lower-risk plans. In addition, the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Tax Act) increased allowable tax-deductible contribution levels for defined benefit plans in general, including contribution levels for 412(e)(3)/412(i) plans (already effectively higher in early plan years than other defined benefit plans).

Much of the attention that 412(e)(3)/412(i) plans received, however, was not positive. Some plan promoters aggressively pushed the envelope in terms of funding and design, attempting to increase up-front tax-deductible contribution levels and provide enhanced benefits to owner-participants. Examples of these plans include:

  • Plans that increase the amount of life insurance in the plan beyond the level historically considered "incidental," based on the fact that the plan itself limits participants to life insurance benefits within the accepted incidental levels. This has the effect of increasing up-front deductible contribution levels.
  • Plans that utilize annuity and insurance contracts with artificially low guaranteed growth rates, again having the effect of increasing up-front deductible contribution levels.
  • Plans that utilize insurance policies with cash value kept artificially low during early years, anticipating that the insurance policy will be distributed or sold to the plan participant before the cash value grows substantially. Such plans would allow a participant to distribute or purchase the insurance policy from the plan after a few years based on the policy's "fair market value" (arguably the suppressed cash value of the policy), only to see the cash value quickly increase in later years. Insurance policies utilized by these plans are often described as "springing" cash value policies.

In response, the Treasury Department and the IRS have issued guidance intended to curb perceived abuses. This guidance is summarized below.

If you're considering a 412(e)(3) plan, be sure to consult with a retirement plan specialist and tax professional who can help you sort through the potential problems and issues surrounding these plans.

In response to the perceived 412(e)(3)/412(i) plan abuses described above, the Treasury Department and the Internal Revenue Service have issued the following guidance:

Proposed Regulations (Prop. Treas. Reg. § 1.402(a)-1(a)(1)(iii), Prop. Treas. Reg. § 1.402(a)-1(a)(2), Prop. Treas. Reg. § 1.79-1(d)(3), Prop. Treas. Reg. § 1.83-3(e)) -- These proposed regulations state that any life insurance contract transferred from an employer or a tax-qualified plan to an employee must be taxed at its full fair market value (i.e., the value of all rights under the contract) and not merely the cash value of the contract. These proposed regulations would apply to transfers made on or after February 13, 2004.

Revenue Procedure 2004-16--This revenue procedure provides a temporary safe harbor for determining fair market value of a life insurance contract upon distribution from a qualified retirement plan.

Revenue Ruling 2004-20--This ruling holds that a plan does not qualify as a 412(i) plan if the plan holds life insurance contracts and annuity contracts that provide for greater benefits at a participant's normal retirement age than the benefits provided under the terms of the plan itself. The ruling also holds that an employer contribution used to purchase life insurance coverage for a participant in excess of the death benefit provided to a participant's beneficiaries under the terms of the plan is not fully deductible in the current year (such an arrangement may also be considered a listed transaction for purposes of tax-shelter reporting requirements).

Revenue Ruling 2004-21--This ruling holds that a plan funded with life insurance contracts does not satisfy anti-discrimination rules if the rights of non-highly compensated employees to purchase life insurance contracts from the plan prior to distribution of retirement benefits are not of equal or greater value than the purchase rights of highly compensated employees.