I have received a lot of questions lately about the "412(i)." It’s a hot item. However, a 412(i) is not the new model from BMW. Rather, a 412(i) is a kind of pension plan, and it bears no resemblance to a BMW.

BMWs are sleek, expensive, fashionable, and make a lifestyle statement about the owner. A 412(i) is a plain vanilla, ho-hum, fuddy-duddy pension plan. A 412(i) pension plan also makes a lifestyle statement about its owner: old and boring. Bruce Springsteen drives a BMW. If he were still alive, Lawrence Welk would have a 412(i). My son in college wants a BMW. I, on the other hand, am in the market for a 412(i).

Why all the interest in 412(i) plans lately? Keep reading.

Background Qualified retirement plans fall into one of two broad groups. Just as human beings are either male or female, retirement plans are either "defined contribution" plans or "defined benefit" plans.

Defined contribution ("DC") plans include profit sharing plans, 401(k) plans, SIMPLE plans, and SEPs. In a DC plan, no promise is made to the employee on what will be paid out at retirement. The employer makes annual contributions, the contributions are invested, and at retirement the employee gets whatever happens to be in his account. No more, no less.

Defined benefit ("DB") plans make a promise on retirement benefits. If the employee works until retirement, he will get a specific amount each month for life.

DB plans have one huge advantage over DC plans. The DB plan can receive much larger annual (deductible) contributions than its DC plan counterpart. DB plans, however, fell out of favor in the mid-1980s because of complicated and onerous tax law changes. DB plans require a lot of maintenance, and administrative costs for them are high. In the past 15 years, most small employers terminated their DB plans and switched to DC plans, most notably the 401(k).

412(i) Plans in a Nutshell A 412(i) plan is a defined benefit plan. It is described in section 412(i) of the Internal Revenue Code, which addresses funding requirements for DB plans. Actually, subsection 412(i) is an exception from many of the burdensome rules in section 412 that apply to most DB plans.

The 412(i) plan is not new. It predates ERISA. The key features of a 412(i) plan are:

It is a full fledged DB plan. The basic qualified plan rules for employee coverage and participation apply to 412(i) plans.

Because it is a DB plan, the 412(i) plan permits much larger contributions than DC plans for older, higher paid employees. DC plans are limited to $40,000 per year contributions per employee. A 412(i) DB plan can accommodate annual contributions of more than $100,000 per participant.

The plan must be funded only with insurance or annuity contracts.

The retirement benefits must be fully guaranteed by the insurance company.

The 412(i) plan is exempt from the minimum funding requirements of section 412.

The plan must provide for level annual premiums until retirement.

Participant loans are prohibited.

The insurance contracts must not be subject to a security interest.

An actuary is not required.

Customary annual administration, such as 5500 filings, is required.

Why the New Interest in 412(i) Plans? In the old days, these plans were known as "fully insured defined benefit plans." If your insurance agent called and said he wanted to show you a "fully insured defined benefit plan" you’d gag.

Since these plans have been around for so long and have been ignored, why the new interest in them? Answer: In the right circumstances, the owner can put in an awful lot of money, take a full tax deduction, pay little (or virtually nothing) for employees, and take no investment risk. Now, that’s my kind of retirement plan.

These plans were ignored in the past because the investments must be in insurance products. By their nature, insurance policy and annuity returns are low--hardly attractive compared to the 20% annual returns in the stock market. Remember those days? Now that the stock market has tanked, and interest rates are at a 40 year low, those insurance products rates of return don’t look so bad after all. It beats losing money.

Who is a Candidate for a 412(i) Plan? Not every employer is a candidate for a 412(i) plan. In fact, few employers are. But, if the circumstances are right, the 412(i) plan can be a jewel.

The employer with the following profile should look further into 412(i) plans.

There should only be a handful of employees, no more than five or six. The fewer the better. One is perfect. And, the employees should be younger than 45. Employee turnover is an advantage.

The owner should be at least 45 years old. That’s the point where the actuarial tables work to your advantage (i.e., you’re gonna die sooner than those young turks in your company).

The business must be successful. The owner should be making at least $100,000 per year, and the more the better.

The business should not have any other qualified plans and it should not be part of a controlled group or affiliated service group.

The owner must expect that his income from the business will steadily continue for 10 years or more. The income must be predictable—no "feast or famine," because level contributions must be made each year. No exceptions.

The owner should not be planning a structural change to his business, such as a merger, expansion of personnel, or business acquisition.

This profile describes successful consultants and very small professional firms. The business must make a lot of money consistently for an older owner who does not need an entourage of support people to generate the cash.

Disadvantages of 412(i) Plans The disadvantages of 412(i) plans are clear. The 412(i) is inflexible. All investments must be in insurance products, so annual returns are modest with no "upside" potential. An unexpected change in the business—merger, decline of annual income, disability--- will throw a monkey wrench into an otherwise great opportunity. The key to success is making sure that the 412(i) is the right fit at the outset.

How to Set Up a 412(i) Plan You must contact an insurance company or agent that is knowledgeable about 412(i) plans. The annuities and insurance policies used must be carefully selected and tailored for each particular owner. The insurance company should provide the plan documents and annual administrative support as well.

How to contact Gene Parrs