412(e)(3) Plan Requirements: The Six Conditions in the Code

Technical Summary: What Section 412(e)(3) Requires

A fully insured defined-benefit plan is described in section 412(e)(3) of the Internal Revenue Code when it meets six conditions at once, or when it is funded exclusively by group contracts that regulations determine to have the same characteristics. The six conditions are exclusive funding by insurance contracts, level annual premiums, benefits equal to contract benefits and backed by a licensed carrier, premiums paid without lapse, no security interest, and no policy loans.

This question usually comes from owners of closely held businesses and professional practices. They are weighing a retirement benefit funded through insurance contracts, or they already administer one. Under 26 U.S.C. § 412(e)(2)(B), a plan described in paragraph (3) is excepted from the minimum funding standards of section 412. The governing regulation is 26 C.F.R. § 1.412(i)-1. The IRS Fully insured 412(e)(3) plans page discusses the requirements that apply to these plans. The plan is a defined-benefit plan. The insurance contracts are its funding vehicle, not an add-on. The IRS notes that before the Pension Protection Act of 2006 these were called "412(i) plans." The same structure appears under both names.

Definition: What a Fully Insured Defined-Benefit Plan Is

A defined-benefit plan promises a stated retirement benefit, set by a formula in the plan document, rather than whatever an individual account happens to hold. The business problem it addresses is retirement income for owners and employees. Insurance enters only as the way the plan pays for that promise.

"Fully insured" is the IRS's name for a plan described in section 412(e)(3), not a marketing label. Under 26 U.S.C. § 412(e)(3), the plan is funded exclusively by insurance contracts. Those contracts may be individual contracts, group contracts with the same characteristics, or, under 26 C.F.R. § 1.412(i)-1(d), "a combination of individual contracts and a group contract." Other defined-benefit plans generally are subject to section 412's minimum funding standards, because section 412(e)(1) applies the section to a plan with a qualified trust, subject to the exceptions in paragraph (2).

Section 412(e)(1) ties these plans to section 401(a) or to the qualified annuity plan rules. A fully insured plan therefore still has to satisfy the qualified-plan rules, including the rules in sections 401(a)(4) and 410. The site's explainer on the former 412(i) plan name traces the renumbering.

Applicable Rules: The Statutory and Regulatory Framework

The following federal authorities shape these plans:

• 26 U.S.C. § 412(e)(3). This is the operative paragraph. It lists conditions (A) through (F) and contains the group-contract sentence.
• 26 C.F.R. § 1.412(i)-1. The regulation provides that a plan satisfying its requirements for a plan year "is not subject to the requirements of section 412 for that plan year." The IRS notes that the regulation was not updated after 2006 and still carries the "412(i)" numbering.
• 26 U.S.C. § 404. This section governs the deduction for employer contributions.
• 26 U.S.C. § 415(b). This section sets the annual benefit limit for defined-benefit plans.
• 26 U.S.C. §§ 401(a)(4) and 410. These sections set the nondiscrimination and minimum participation rules.
• Rev. Rul. 2004-20 and Rev. Rul. 2004-21. These rulings address excess life insurance, listed transactions and purchase rights.
• The IRS Issue Snapshot. The IRS page on fully insured 412(e)(3) plans says the 2004 and 2005 guidance was issued "to stop abuses involving the use of certain specially designed life insurance policies in retirement plans."

Requirements: The Six Conditions Under 26 U.S.C. § 412(e)(3)(A)–(F)

Section 412(e)(3) of the Internal Revenue Code provides that a plan is described in that paragraph if:

• (A) "the plan is funded exclusively by the purchase of individual insurance contracts,"
• (B) "such contracts provide for level annual premium payments to be paid extending not later than the retirement age for each individual participating in the plan, and commencing with the date the individual became a participant in the plan (or, in the case of an increase in benefits, commencing at the time such increase becomes effective),"
• (C) "benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan," and an insurance carrier "licensed under the laws of a State to do business with the plan" backs those benefits "to the extent premiums have been paid,"
• (D) "premiums payable for the plan year, and all prior plan years, under such contracts have been paid before lapse or there is reinstatement of the policy,"
• (E) "no rights under such contracts have been subject to a security interest at any time during the plan year, and"
• (F) "no policy loans are outstanding at any time during the plan year."

The statute then adds the group-contract sentence: "A plan funded exclusively by the purchase of group insurance contracts which is determined under regulations prescribed by the Secretary to have the same characteristics as contracts described in the preceding sentence shall be treated as a plan described in this paragraph."

The six conditions are cumulative. A plan that misses one for a plan year is not described in paragraph (3) for that year, and section 412's minimum funding rules then apply to it. Nondiscrimination and participation are not among the six conditions. They apply separately, because the plan remains a qualified plan.

How the Rules Work: Contributions, Benefits and Contract Mechanics

Employer contributions are paid to or under the plan, and the plan is funded by the purchase of insurance contracts for its participants. Premiums are paid under the plan, and benefits are paid under its terms.

Premiums. Condition (B) requires level annual premiums. They run from the date participation begins, or from the date a benefit increase takes effect, and end no later than retirement age. A premium schedule that rises and falls does not match that description.

Benefits. Under condition (C), the plan's benefits equal the contract benefits at normal retirement age, and a licensed carrier backs those benefits "to the extent premiums have been paid."

Lapse, pledges and loans. Conditions (D), (E) and (F) are tested within each plan year. A pledge of contract rights at any time during the year fails (E). A loan outstanding at any time during the year fails (F).

Deductions. Section 404(a) provides that contributions to a pension plan are deductible "under this section, subject, however, to the following limitations," so the deduction is not simply the premium. Section 264(a)(1) separately bars a deduction for premiums "if the taxpayer is directly or indirectly a beneficiary under the policy." The site's page on key person premium deductibility covers that rule. Rev. Rul. 2004-20 holds that contributions used to buy life insurance "in excess of the participant's death benefit provided under the plan" are not fully deductible when contributed. Instead, they carry over within section 404 limits.

Benefit limit. Section 415(b)(1) caps the annual benefit at the lesser of $160,000 or "100 percent of the participant's average compensation for his high 3 years." The $160,000 figure is the amount stated in the 2024 edition of the Code; section 415(d)(1) requires the Secretary to adjust it annually for increases in the cost of living, so the amount in effect for a given year can differ.

Purchase rights. Rev. Rul. 2004-21 holds that a plan fails section 401(a)(4) where highly compensated employees may buy the contracts from the plan before distribution, and the rights of non-highly compensated employees are "not of inherently equal or greater value."

Who This Is For: Employers and Plan Structures That Use Section 412(e)(3)

Readers here are usually owners and finance leads of closely held employers. These include partnerships, S corporations, C corporations and professional practices that want a defined retirement benefit funded with insurance contracts.

The plan is an employer's plan under 26 U.S.C. § 412(e)(1), tied to section 401(a) or the qualified annuity plan rules. It has to cover employees in line with sections 401(a)(4) and 410. A plan designed so that only owners benefit runs into those rules.

The contracts come from a carrier "licensed under the laws of a State to do business with the plan." Insurance licensing and product rules vary by state. This page explains federal tax rules only. The site's overview of business life insurance places this plan alongside other insurance-funded business strategies.