412(e)(3) Plan vs. 401(k): Defined Benefit vs. Defined Contribution for Business Owners

Short Answer: How a 412(e)(3) Plan and a 401(k) Differ

A 412(e)(3) plan is a fully insured defined-benefit plan. It promises a retirement benefit set by a formula and is funded only with individual insurance or annuity contracts bought with level annual premiums. A 401(k) is a defined-contribution plan. It sets what goes into each participant's account, not what comes out. The real differences are the promise each plan makes and who carries the funding risk.

Owner-employees of closely held companies and professional practices may weigh the two plans when deciding how the business will fund the owners' retirement. Section 412(e)(3) plans were known as 412(i) plans before the Pension Protection Act of 2006. Business Life Insurance treats the insurance contracts as the funding mechanism inside the plan, never as the plan itself.

At-a-Glance Comparison: 412(e)(3) Plan vs. 401(k)

What a 412(e)(3) Fully Insured Defined-Benefit Plan Is

A defined-benefit plan promises a participant a specific benefit at retirement, determined by the plan's formula. The plan does not promise an account balance. A section 412(e)(3) plan delivers that promise entirely through insurance contracts.

Mechanics. The employer contributes to the plan. Under 26 C.F.R. § 1.412(i)-1, the contracts are bought from an insurance company, and the purchase "may be made either directly by the employer or through the use of a custodial account or trust." Plan benefits equal the benefits provided under each contract at normal retirement age.

To be described in 26 U.S.C. § 412(e)(3), a plan must meet all six conditions:

• (A) it is "funded exclusively by the purchase of individual insurance contracts";
• (B) the contracts provide level annual premiums, starting when the individual becomes a participant and extending no later than retirement age;
• (C) plan benefits equal the benefits under each contract at normal retirement age and are backed by an insurance carrier licensed under the laws of a State to do business with the plan "to the extent premiums have been paid";
• (D) the premiums payable for the plan year and all prior plan years have been paid before lapse, or the policy has been reinstated;
• (E) no rights under the contracts have been subject to a security interest during the plan year;
• (F) no policy loans are outstanding at any time during the plan year.

The IRS page on fully insured 412(e)(3) plans notes that the former section 412(i) rules were moved to section 412(e)(3) "effective for plan years beginning after December 31, 2007." It also notes that the regulations remain at Treas. Reg. § 1.412(i)-1. The six statutory conditions and the former 412(i) name each have their own page.

Contributions are deductible only if they would otherwise be deductible, and then within section 404 limits, and benefits are limited by section 415(b). Plan design, contributions and deductions need individual review by a qualified tax professional.

What a 401(k) Plan Is

The IRS 401(k) Plan Overview defines a 401(k) plan as "a qualified plan that includes a feature allowing an employee to elect to have the employer contribute a portion of the employee's wages to an individual account under the plan." The underlying plan "can be a profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan."

Because it is a defined-contribution plan, the 401(k) fixes what goes into each account, not the benefit at retirement. The feature that defines the plan is the elective deferral:

• Elective deferrals. These are wages the employee chooses to defer. The IRS Overview says these deferrals generally "are not subject to federal income tax withholding at the time of deferral." Roth elective deferrals, by contrast, "are included in the employee's taxable income in the year of the deferral."

The IRS contribution limits page states an overall limit of "$72,000 in 2026 ($80,000 including catch-up contributions or up to $83,250 for those age 60 to 63)." The participant's account carries the investment results, so the employer does not promise a benefit amount.

A business that is considering a 412(e)(3) plan and a 401(k) together is looking at two plans with separate limits under different subsections of section 415.

Key Structural Differences Between the Two Plans

Funding risk is where the two plans diverge most sharply.

• Who carries the risk. In a 412(e)(3) plan, the employer funds a promised benefit, and the statute requires the plan's benefits to be backed by a licensed insurer "to the extent premiums have been paid" (§ 412(e)(3)(C)). In a 401(k), the participant's account carries the investment results.
• Funding vehicle. A 412(e)(3) plan is funded exclusively by individual insurance or annuity contracts, or by group contracts that the regulations treat the same way (§ 412(e)(3)(A); 26 C.F.R. § 1.412(i)-1). A 401(k) holds individual accounts.
• Actuarial work. A defined-benefit formula needs actuarial pricing to turn a benefit into a premium. The professional requirements for a particular plan are confirmed with the plan's advisers.
• Flexibility. Section 412(e)(3)(B) requires level annual premiums. Contributions to a 401(k) may vary within the 2026 limits.
• Limits. A 412(e)(3) plan's benefit is limited by § 415(b): the lesser of 100 percent of the participant's average compensation for his high 3 years and a dollar limit, which is $290,000 for 2026 (Notice 2025-67). A 401(k)'s annual additions are limited by § 415(c): the lesser of 100 percent of the participant's compensation and a dollar limit, which is $72,000 for 2026 (Notice 2025-67).

Tax Treatment Compared: Contributions, Growth and Distributions

Before any deduction is discussed, one rule frames the 412(e)(3) side. Section 264(a)(1) provides that "No deduction shall be allowed for— (1) Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract." How that rule interacts with contracts held by a plan or trust turns on the ownership and beneficiary facts of the arrangement.

Contributions. Section 404(a) provides that employer contributions to a pension, profit-sharing or annuity plan "shall be deductible under this section," but only if they would otherwise be deductible and only within its annual limits. For a profit-sharing or money purchase pension plan, the IRS contribution limits page says the employer's deduction "cannot be more than 25% of the compensation paid (or accrued) during the year to eligible employees participating in the plan." The IRS 412(e)(3) page adds that deducting premiums on a life insurance contract whose death benefit "exceeds the participant's death benefit under the plan by more than $100,000" makes the arrangement "a 'listed transaction'" (Rev. Rul. 2004-20). Deductions for each plan are covered on the page about 412(e)(3) plan tax deductions.

Life insurance inside the plan. The IRS 412(e)(3) page states that the amount a participant reports as income "is equivalent to the premium paid on a term life insurance policy for 1 year for the face value of the plan policy." How life insurance inside a 412(e)(3) plan is taxed has its own page.

Distributions. Section 72(t) adds a 10% tax to the includible portion of amounts received from a qualified retirement plan. Its exceptions include distributions:

• after age 59½;
• after the employee's death;
• because of disability;
• after separation from service after age 55.

How a particular distribution is taxed depends on the plan and on the facts of that distribution.

Death benefit. Section 101(a)(1) generally excludes life insurance death proceeds from gross income. Section 101(a)(2) limits that exclusion after a transfer for value. For an employer-owned contract, section 101(j) caps the exclusion at premiums and other amounts paid, unless a 101(j)(2) exception applies and written notice and consent were given before the contract was issued. Whether that rule reaches contracts held by a plan depends on the facts of the arrangement.