Section 412(e)(3) Plans: Fully Insured Defined Benefit Plans (Formerly 412(i))

Tax Treatment of Contributions, Benefits and Death Proceeds

Three separate questions arise: whether the employer may deduct what it contributes, how large the promised benefit may be, and how death proceeds are treated.

Employer contributions: section 404

Section 404(a) of the Internal Revenue Code provides that contributions paid by an employer to a pension plan "shall not be deductible under this chapter; but, if they would otherwise be deductible, they shall be deductible under this section, subject, however, to the following limitations." For a defined-benefit plan other than a multiemployer plan, section 404(a)(1)(A) points to an amount "determined under subsection (o)." The deduction is therefore not a deduction for insurance; it is a deduction for a plan contribution, allowed only up to the section 404 limit.

Rev. Rul. 2004-20 limits and defers the deduction for certain employer contributions used to purchase life insurance coverage for a participant in a defined benefit plan. It states that "Employer contributions under a qualified defined benefit plan that are used to purchase life insurance coverage for a participant in excess of the participant's death benefit provided under the plan are not fully deductible when contributed, but are carried over to be treated as contributions in future years and deductible in future years when other contributions to the plan that are taken into account for the taxable year are less than the maximum amount deductible for the year pursuant to the limits of § 404."

Benefit limit: section 415(b)

Section 415(b)(1) provides that benefits exceed the limit "if, when expressed as an annual benefit ... such annual benefit is greater than the lesser of— (A) $160,000, or (B) 100 percent of the participant's average compensation for his high 3 years." That dollar figure is the base amount printed in the 2024 edition of the United States Code; section 415(d)(1) directs the Secretary to adjust it annually for cost-of-living increases, so the figure that applies in a given year is confirmed for that year. Section 415(b)(2)(A) defines "annual benefit" as "a benefit payable annually in the form of a straight life annuity (with no ancillary benefits)," and section 415(b)(2)(B) adjusts other benefit forms to that equivalent. Because section 412(e)(3)(C) makes the plan benefit equal to the contract benefit, the section 415(b) limit also constrains how large the contracts may be.

Distributions to participants

Benefits paid from a qualified plan are generally included in the participant's income when received, under the rules that govern qualified-plan distributions; how a particular distribution is taxed, including a distribution of a contract itself, depends on the plan and the contract.

Death proceeds: section 101

Section 101(a)(1) provides that "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured," except as other provisions provide. Two of those provisions matter in business planning. Under section 101(a)(2), in a "transfer for a valuable consideration" of a contract or an interest in it, the exclusion "shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee," with exceptions in section 101(a)(2)(B) for a transfer "to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer." The section 101(j) cap for employer-owned contracts is the second. How proceeds paid to a plan, and then paid out under the plan, are taxed is a separate question from the section 101 exclusion itself.

Any transfer of a plan-held contract, whether to a participant, an owner or the business, and the resulting income-tax and transfer-for-value treatment, needs individual review of the contracts involved by the insurers and a qualified tax professional. The way owners structure transfers in other settings is covered on the site's page on cross-purchase buy-sell agreements.

What Affects Contribution Amounts and Plan Cost

No single figure describes what a fully insured defined benefit plan costs; the amount follows from a handful of variables, and premium amounts and contract charges vary from insurer to insurer and are confirmed with the insurers involved.

• The benefit formula. Under section 412(e)(3)(C), plan benefits equal the contract benefits at normal retirement age, so the promised benefit drives the size of the contract and therefore the premium.
• Age and years to retirement. Because section 412(e)(3)(B) spreads level premiums from entry to retirement age, fewer years to retirement means fewer premiums to fund the same benefit, and each premium is correspondingly larger.
• Compensation history. The "high 3 years" compensation measure in section 415(b)(1)(B) sets one ceiling on the benefit, and with it a ceiling on contract size.
• Number of eligible employees. Each covered employee's benefit is funded by its own contracts, so headcount and the employees' ages and pay all affect total cost.
• Contract type. Annuity contracts, life insurance contracts and combinations have different premium structures, and terms, charges and features vary by insurer.
• The deduction limit. Section 404 caps the deductible amount; contributions above it are not deductible when paid, and Rev. Rul. 2004-20 describes the carryover treatment for contributions used for excess life insurance coverage.

The site's 412(e)(3) calculator illustrates how these variables interact; any figure it produces is an educational illustration, not a plan design or a contribution amount for any business.

Common Structures and Contract Combinations

Two broad designs appear in practice, and both must satisfy every one of the six requirements.

Annuity-only funding

In the simpler design, the plan buys an individual annuity contract for each participant, sized so that the contract's benefit at normal retirement age equals the plan's promised benefit. The contract is an annuity contract rather than a life insurance contract.

Life insurance combined with annuity contracts

In the second design, the plan holds both life insurance and annuity contracts for a participant, with the life insurance providing a death benefit before retirement and the contracts together funding the retirement benefit. Section 412(e)(3)(A) still requires funding "exclusively by the purchase of individual insurance contracts," and Treas. Reg. § 1.412(i)-1(c) addresses group plans funded by "group annuity or group insurance contracts, or a combination thereof." Rev. Rul. 2004-20 gives an example in which a plan "cannot be a section 412(i) plan if the plan holds life insurance contracts and annuity contracts for the benefit of a participant that provide for benefits at normal retirement age in excess of the participant's benefits at normal retirement age under the terms of the plan." The combined contracts therefore cannot promise more at retirement than the plan does.

The incidental death benefit rule

The IRS page on fully insured plans lists an "Incidental death benefit rule" among the requirements it examines. The precise measure that applies to a given plan and contract falls within the plan-design review already described.

Individual and group contracts

The statute's primary description uses individual contracts, and it separately treats as described a plan funded exclusively by group contracts that regulations determine "to have the same characteristics." Contract terms, forms and availability vary by insurer and by state, and are confirmed with the insurers involved.

Potential Advantages of the Fully Insured Structure

What sponsors find attractive here comes from the statute's own design. Each point below is a characteristic of the structure, not an outcome for any particular plan.

• A contribution pattern set by contract. Section 412(e)(3)(B) calls for "level annual premium payments," so the yearly funding obligation for each participant is fixed by the contracts rather than recalculated from investment performance.
• Exemption from the minimum funding standards. Section 412(e)(2)(B) excludes a plan described in paragraph (3) from section 412. The Department of Labor's 2025 Instructions for Form 5500 state that if a plan is funded exclusively by such contracts, "the otherwise applicable minimum funding requirements of Code section 412 and ERISA section 302 do not apply for the year and neither the Schedule MB nor the Schedule SB is required to be filed."
• Room for larger contributions over a short horizon. A defined-benefit design can call for larger annual contributions than defined-contribution plans for participants close to retirement, always within section 404 and section 415(b).
• Carrier-backed benefits. Section 412(e)(3)(C) requires plan benefits to be backed by an insurance carrier to the extent premiums have been paid, a contract feature that ties benefit security to the insurer and to premium payment.
• A death benefit before retirement. Where the plan holds life insurance within the incidental limit, the contract provides a death benefit to the plan during the accumulation years.
• Possible reporting relief. Under 29 C.F.R. § 2520.104-44(b)(2), a pension plan whose benefits are "provided exclusively through allocated insurance contracts or policies" under which benefit payments are fully backed by a qualified insurance company, and paid as the regulation describes, may be exempt from certain annual reporting items, including the independent qualified public accountant examination; paragraph (d) states that this "does not exempt any plan from filing an annual report form."

Important Considerations and Compliance Risks

IRS attention to these plans is the starting point for any evaluation of them.

Listed transactions under Rev. Rul. 2004-20

Rev. Rul. 2004-20 states that transactions "the same as, or substantially similar to, the transaction described in Situation 2 of this revenue ruling are identified as 'listed transactions' ... effective February 13, 2004 ... provided that the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that exceeds the participant's death benefit under the plan by more than $100,000." The IRS fully insured plan page restates the threshold and cites the Treasury regulations under which listed transactions carry federal reporting consequences. The IRS Listed Transactions page still lists Rev. Rul. 2004-20 under the heading "Abusive Transactions Involving Insurance Policies in IRC 412(i) Retirement Plans." The IRS page also notes that the issues in its 2004 and 2005 guidance "form the basis of some of the issue indicators or audit tips," which signals how these plans are examined.

The requirements apply every plan year

Requirements (D), (E) and (F) are written in terms of "the plan year" and "all prior plan years." A plan that meets them one year and not the next is not described in paragraph (3) for the year it fails, and the general minimum funding standards apply to it for that year.

Policy loans and security interests

Requirement (E) bars any security interest in rights under the contracts "at any time during the plan year," and requirement (F) bars outstanding policy loans "at any time during the plan year." A loan or pledge for even part of a year, such as using the contracts as collateral for a business loan, is enough to fall outside paragraph (3).

Qualified-plan obligations continue

The funding exemption leaves the plan's other obligations in place. Annual reporting continues: under 29 C.F.R. § 2520.104-44(d) the limited exemption for certain insured plans "does not exempt any plan from filing an annual report form." The Form 5500 instructions relieve a plan funded exclusively by section 412(e)(3) insurance contracts of Schedule MB and Schedule SB.

Nondeductible contributions

Section 4972 imposes a tax on "nondeductible contributions," which section 4972(c)(1) defines to include "the excess (if any) of— (i) the amount contributed for the taxable year by the employer to or under such plan, over (ii) the amount allowable as a deduction under section 404." Contributing more than section 404 allows can therefore raise a section 4972 question, but section 4972(c)(7) provides that "an employer may elect for such year not to take into account any contributions to a defined benefit plan except, in the case of a multiemployer plan, to the extent that such contributions exceed the full-funding limitation (as defined in section 431(c)(6))," so whether a tax applies depends on that election and the plan's facts.

Alternatives to a Section 412(e)(3) Plan

Other qualified plans meet some of the same goals with different funding and compliance features, and the choice among them depends on the employer's workforce, cash flow and objectives.

• A traditional defined-benefit plan funded through a trust with an investment portfolio remains subject to the minimum funding standards of section 412 and the actuarial work that comes with them; the site has a separate comparison of the 412(e)(3) and traditional defined-benefit designs.
• A cash balance plan is a defined-benefit plan expressed through individual account-like balances; the site's comparison of 412(e)(3) and cash balance plans addresses the differences.
• A 401(k) or profit-sharing plan is a defined-contribution plan; section 412(e)(2)(A) excludes "any profit-sharing or stock bonus plan" from the minimum funding standards altogether, and the site's 412(e)(3)-versus-401(k) comparison covers the differences in contributions and mechanics.

Business Life Insurance describes these differences without ranking the options. The broader role of insurance across business planning is covered in the site's general guide to business life insurance.

Hypothetical Example: Estimating a Contribution Range

This example is hypothetical. Its figures are round numbers chosen to show the mechanics; they are not statutory limits, insurer quotes or anyone's actual result.

Assumptions

• A one-owner professional corporation with no other eligible employees.
• The owner is 10 years from the plan's normal retirement age.
• The owner's average compensation for the high 3 years is $200,000.
• The plan's formula promises an annual straight-life benefit of $100,000 at normal retirement age.
• An annuity-only design, with an insurer illustrating a level annual premium of $80,000 to fund that benefit.
• An actuarial calculation sets the section 404 deductible limit for the first year at $70,000.

Step 1: Check the benefit against section 415(b)(1)(B). 100 percent × $200,000 high-3 average compensation = $200,000. The $100,000 promised benefit is below $200,000, so this prong does not reduce it. The dollar prong in section 415(b)(1)(A) would be checked separately against the figure that applies for the year.

Step 2: Size the contract under section 412(e)(3)(C). The contract's benefit at normal retirement age must equal the plan benefit: $100,000 a year.

Step 3: Apply the level-premium requirement of section 412(e)(3)(B). $80,000 a year × 10 years = $800,000 in total premiums, paid in equal annual amounts from entry into the plan to retirement age.

Step 4: Compare the contribution with the section 404 limit. $80,000 contributed − $70,000 deductible = $10,000 not deductible in the year paid.

Step 5: Note section 4972. The $10,000 excess fits the section 4972(c)(1)(A) definition of a nondeductible contribution for that year, before any election under section 4972(c)(7), which lets an employer elect not to take contributions to a defined benefit plan into account (with an exception for multiemployer plans). Whether a section 4972 tax applies therefore depends on that election.

The example shows how the promised benefit drives the contract, how section 415(b) caps the benefit and how section 404 limits the deduction. Actual figures depend on the contracts, the insurer and the participant's facts, and are confirmed with the insurers and a qualified tax professional.