412(e)(3) vs Cash Balance Plan: How Two Defined Benefit Approaches Compare

Short Answer: Two Defined Benefit Plans, Different Funding Engines

A 412(e)(3) plan and a cash balance plan are both defined benefit plans. The difference is how the promised benefit is built. A 412(e)(3) plan is funded exclusively by insurance contracts with level annual premiums. A cash balance plan credits each participant's hypothetical account with pay and interest credits. The section 415(b) benefit limit applies to both.

Owner-employees of closely held companies and professional practices may weigh 412e3 vs cash balance. The question is whether the plan's promise should rest on insurance contracts or on credits stated in the plan document.

Business Life Insurance looks at this choice as a business-planning question. The business's cash flow, the size of its workforce and the owner's time to retirement come first. In one design, insurance and annuity contracts are the funding mechanism for the plan. This page does not treat either plan as a 401(k) comparison.

At-a-Glance Comparison

What a 412(e)(3) Fully Insured Plan Is

Section 412(e)(3) describes a specific kind of defined benefit plan. In such a plan, insurance and annuity contracts are the plan's only funding. The plan must meet each of the six statutory conditions:

• (A) Exclusive funding. The plan is "funded exclusively by the purchase of individual insurance contracts."
• (B) Level premiums. The contracts call for level annual premiums. These run from the date the individual became a participant (or the date a benefit increase takes effect) and extend no later than that participant's retirement age.
• (C) Benefits match the contracts. Plan benefits equal the contract benefits at normal retirement age. Section 412(e)(3)(C) requires that they be 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) Premiums paid. Premiums for the current and prior plan years have been paid before lapse, or the policy has been reinstated.
• (E) No security interest. No rights under the contracts have been subject to a security interest during the plan year.
• (F) No policy loans. No policy loans are outstanding during the plan year.

Group contracts with the same characteristics are treated alike under the statute and 26 C.F.R. § 1.412(i)-1. Under 26 U.S.C. § 412(e)(2)(B), a plan described in section 412(e)(3) is excepted from the minimum funding rules of section 412.

The IRS page on these plans notes that they "were known as '412(i) plans'" before the Pension Protection Act of 2006. The detailed conditions appear on the site's page on 412(e)(3) plan requirements. The site's page on section 412(e)(3) plans gives the full overview.

Section 264(a)(1) is a separate rule on the deduction of premiums. It allows no deduction for premiums on a life insurance policy or annuity contract "if the taxpayer is directly or indirectly a beneficiary under the policy or contract."

Plan design, contributions and deductions for a 412(e)(3) plan need individual review of the contracts involved by a qualified tax professional.

What a Cash Balance Plan Is

The IRS Retirement Plans Definitions page describes a cash balance plan as "a type of defined benefit plan that includes some elements that are similar to a defined contribution plan because the benefit amount is computed based on a formula using contribution and earning credits, and each participant has a hypothetical account."

The IRS plan-conversion page explains how the credits work: "Usually, an employee receives an annual credit of some percentage of his or her salary and an annual interest credit (either fixed or variable, linked to an index)." These credits accumulate for every year of employment.

When the employee retires or leaves, the employee may choose to take the total amount based on these credits in a lump sum or as an annuity. Spousal consent applies where required.

The account is hypothetical. It is a measure of the benefit, not a funding vehicle. A plan is described in section 412(e)(3) only if it meets every one of the six conditions, including exclusive funding by individual insurance contracts. As a defined benefit plan, a cash balance plan is subject to section 415(b). Employer contributions to it are deductible only if they would otherwise be deductible, and then within the limits of section 404(a).

Key Structural Differences

Funding is the dividing line in the comparison of a cash balance plan vs a fully insured plan.

• Source of the benefit. In a 412(e)(3) plan, the contracts themselves produce the benefit. In a cash balance plan, the benefit is the hypothetical balance produced by the plan's credits.
• Shape of contributions. In a 412(e)(3) plan, section 412(e)(3)(B) requires level annual premiums. In a cash balance plan, the IRS describes the benefit by the credits stated in the plan, not by level premiums. How much its contributions vary from year to year is a design question for the plan's actuary.
• Backing of the benefit. In a 412(e)(3) plan, the benefit is backed by the carrier to the extent premiums have been paid. In a cash balance plan, the benefit rests on credits stated in the plan, and the interest credit is "either fixed or variable, linked to an index."
• Funding rules. A plan described in section 412(e)(3) is exempt from section 412's minimum funding rules under section 412(e)(2)(B). That exemption reaches no other kind of plan.

The IRS has also flagged abuses. The IRS fully insured plans page says it "issued guidance in 2004 and 2005 to stop abuses involving the use of certain specially designed life insurance policies in retirement plans." That guidance includes Rev. Rul. 2004-20.

Tax Treatment Compared

Under section 404(a), employer contributions to a pension plan are deductible only if they would otherwise be deductible, and then "subject, however, to the following limitations." This rule applies to both plans.

Section 264(a)(1), separately, allows no deduction for premiums on a life insurance policy or annuity contract if the taxpayer is directly or indirectly a beneficiary under it. Whether it reaches a particular contract depends on who is a beneficiary under it.

Rev. Rul. 2004-20 sets out further consequences for life insurance inside these plans:

• Excess coverage is not fully deductible. Employer contributions used to buy life insurance coverage above the participant's plan death benefit "are not fully deductible when contributed." They carry over to later years, within section 404 limits.
• Some arrangements are listed transactions. An arrangement in which the employer deducts premiums on a contract whose death benefit exceeds the plan death benefit by more than $100,000 is a "listed transaction."

The site's page on 412(e)(3) plan tax deductions addresses these points in more detail.

On the benefit side, section 415(b) limits the annual benefit under any defined benefit plan. The limit is the lesser of the statute's dollar amount or "100 percent of the participant's average compensation for his high 3 years." The statute states the dollar amount as $160,000, a base figure that is adjusted under section 415(d). The figure for a given year is confirmed with the plan's actuary.

Section 101(a)(1) generally excludes death proceeds from gross income. It is subject to exceptions, including transfer for value in section 101(a)(2) and the employer-owned contract rules in subsection (j). Those rules are covered on the site's employer-owned life insurance pages.