412(e)(3) Plans Beyond the Basics CRN201104-118361 For Producer and Professional Advisor Use Only. Not For Use With The Public.

412(e)(3) Plans Beyond the Basics

CRN201104-118361

For Producer and Professional Advisor Use Only. Not For Use With The Public.

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This presentation is not written or intended as specific tax or legal advice and cannot be relied upon for purposes of avoiding any federal tax penalties.

MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from a qualified tax or legal advisor.

A 412(e)(3) plan must be funded exclusively with individual insurance products, either fixed annuities or a combination of fixed annuities and life insurance. Securities offered through registered representatives of MML Investors Services, Inc., 1295 State Street, Springfield, MA 01111-0001.

Disclosure

For Producer and Professional Advisor Use Only. Not For Use With The Public

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Overview

A 412(e)(3) is a defined benefit plan. This means the contribution to plan is determined by

the benefits to be paid at retirement.

The plan must be sponsored by an employer.


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Qualified Plan Subject to All Requirements

Because a 412(e)(3) plan is a type of qualified retirement plan, it must meet all applicable funding and discrimination rules by the Internal Revenue Service and Department of Labor.

Plans are required to cover all eligible employees. Full-time (over 1,000 hours per year) employees over the age

of 21

Certain plans must meet top heavy requirements.


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Establishment of the Plan

Plans are easy to establish.

Prototype documents are available for § 412 (e)(3) plans.

Plan can be established by the following: S Corporation C Corporation Limited Liability Company Partnership, or Sole Proprietor


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Importance of Third Party Administration

Design plan Census Other documentation

Annual reporting

Establish plan and trust

Tax reporting – Form 5500


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What is Special About 412(e)(3) Plans?

IRC § 412 is entitled “Minimum Funding Standards.”

This section sets out rules for determining funding of Defined Benefit Plans.

Each year, a Defined Benefit Plan has to be reviewed and present value of liabilities for benefits must be determined by an actuary.

Assumptions made on cost of retirement benefits and “investment” returns.


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Fully Insured Plans Under §412(e)(3)

412(e)(3) is an exception to general rules of §412.

With a 412(e)(3) plan, insurance company’s guarantees take place of actuarial analysis mandated by §412.

The Guaranteed Annuity purchase rate determines amounts needed to fund benefit

The guaranteed accumulation or cash accumulation rates determine “investment” performance


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Impact of Qualifying Under §412(e)(3)

No minimum funding standard account.

No full funding limitation.

No reasonable actuarial assumptions.

No Schedule B Form 5500 Enrolled Actuary Certification needed.


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Qualification Under §412(e)(3)

The plan must be funded entirely with annuities, or annuities and life insurance;

The contracts must provide for guaranteed level annual premiums to be paid during anticipated normal working years;


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Qualification Under §412(e)(3) continued

The benefits must be guaranteed by an insurance company;

The premiums for current and all prior years have been paid;

The plan cannot have any outstanding loans;

The performance in excess of guarantees must be used to reduce future contributions.


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Why are §412(e)(3) Plans becoming Popular?

They can generate large deductions because contributions are based on insurance company guarantees.

Guarantees are subject to claims paying ability of insurance company.

Retirement Benefits can be paid to a maximum of $195,000(2009) annually at age 62 (reduced from 65 by EGTRRA*).

*This law contains a “sunset” provision that repeals the Act as of December 31, 2010. Consequently, all tax code changes made under the Act will revert to their status prior to enactment once again on January 1, 2011. Unless there is future legislation the Act will only be effective through the year 2010.


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Guaranteed benefits* not subject to investment risk.

*Guarantees are subject to the claims-paying ability of the issuing companies.

Why are §412(e)(3) Plans becoming Popular?


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Life Insurance in a §412(e)(3) Plan

Life Insurance contracts can be used in addition to annuities.

Life Insurance is subject to “incidental benefit” limitation generally applicable to defined benefit plans:

Treas. Regs limit face amount to 100 times anticipated monthly benefit; or

Rev. Rul. 74-307 allows up to less than 50% of contribution toward ordinary life premium. In most plan documents the limit is expressed as 66 ⅔ of the

theoretical premium. This is an actuarial approximation of 50% of the contribution


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Why have Life Insurance in Plan?

Can provide an additional death benefit.

The “Economic Benefit” is taxable each year.

IRC 72(m)3(b), Reg. Sec. 1.72-16(b): each participant is taxed on the “pure” life insurance benefit.

The “pure” insurance (net amount at risk) is received income tax free by participant’s beneficiaries.


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Contribution Examples

The following examples are all based on the guaranteed rates of the MassMutual Odysseysm Annuity and Pension Whole Life Legacy 65 (paid-up at 65). The Guarantees are subject to the claims-paying ability of the issuing companies.

MassMutual Odysseysm is issued by Massachusetts Mutual Life Insurance Company (MassMutual) in New York and by C.M. Life Insurance Company, a MassMutual subsidiary, in all other states. Whole Life Legacy 65 is issued by MassMutual.

The illustrations used in this presentation are purely hypothetical and are used solely to demonstrate the general concept of 412(e)(3) plans.

The following illustration assumes a guaranteed rate on the Odyssey annuity of 2% for the first 10 years, 3% thereafter. This rate is applicable in many states, however, contracts issued in other states may have different and higher rates which change the following calculation.


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Example for 42 Year Old(unisex – select preferred non-tobacco)

Value required at retirement to produce life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) $1,996,008

Face amount of life Insurance policy 1,000,000

Life insurance policy premium $21,200.00Premiums are payable to age 65

Level annual annuity payment $44,962.75

Total annual outlay

(annuity premium + life insurance premium) $66,162.75

Retirement age of 65 and an anticipated retirement benefit of $10,000 per month and Whole Life Legacy 65 –100 x monthly benefit.


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Value required at retirement to produce life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) $1,996,008

Face amount of life insurance policy 1,627,645

Life insurance policy premium 34,474.69Premiums are payable to age 65

Level annual annuity premium 34,621.90

Total annual outlay (annuity premium + life insurance premium) $69,096.59

Retirement age of 65 and an anticipated retirement benefit of $10,000 per month and Whole Life Legacy 65 based on less than 50% of contribution.


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Example for 42 Year Old (unisex)

Policy: MassMutual Odysseysm Fixed Annuity

Anticipated Monthly Benefit 10,000.00

Value required at retirement to producelife only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) 1,996,008


Retirement age of 65 and an anticipated retirement benefit of $10,000 per month and no life insurance.


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Policy: MassMutual Odysseysm Fixed Annuity Value required at retirement to produce

life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) $1,996,008

Face amount of life insurance policy 1,000,000 Life insurance policy premium 43,380.00

Premiums are payable to age 65 Level annual annuity payment 94,927.83

Retirement age of 65 and an anticipated monthly retirement benefit of $10,000 and funded with Whole Life Legacy 65 - 100 x monthly benefit.

Total annual outlay (annuity premium + life insurance premium) $138,307.83


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Anticipated Monthly Benefit $10,000.00 Value required at retirement to produce

life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) 1,996,008

Face amount of life insurance policy 1,655,987 Life insurance policy premium 71,803.92

Premiums are payable to age 65 Level annual annuity payment 72,109.79

Retirement age of 65 and an anticipated retirement benefit of $10,000 per month and funded with Whole Life Legacy 65 limited by Rev. Rul. 74-307.

Total annual outlay

(annuity premium + life insurance premium) $143,913.71


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Example for 52 Year Old (unisex)

Anticipated Monthly Benefit $10,000.00

Value required at retirement to producelife only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) 1,996,008


Retirement age of 65 and an anticipated monthly retirement benefit of $10,000 and no life insurance.


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§412(e)(3) Summary of Age 52 Year Old Contributions & Comparison with Results for a 42 year old

Starting Age: Age 42 Age 52

Annuity Only Arrangement $61,438 $129,712

Life Insurance @ 100x mo. Benefit $66,163 $138,308 Life Death Benefit ($1 million) ($1 million)

Life Insurance @ < 50% Contrib. $69,096 $143,914

Life Death Benefit ($1,627,645) ($1,655,987)

Retirement age of 65, anticipated monthly retirement benefit of $10,000;Insurance Product LPL 65 (uni-Sex rates) Select Preferred Non-Tobacco


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Investment Performance of Policies

If annuity generates income in excess of guarantee, that increase is used to reduce next year’s premium.

Dividends in excess of guarantee on life insurance policy must be used to reduce premiums.

To the extent performance exceeds guarantees, the costs of the plan will be reduced over time.


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What Happens to Life Policy at Retirement?

Policy may not be kept in Plan. Only “participants” can receive life protection.

Policy can be distributed as a partial lump sum distribution. The distribution will be income taxable.

Policy can be purchased from plan by the plan participant at fair market value.

Policy can be surrendered and the cash used to provide retirement benefit.


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Example of Sale of Policy

Purchase by insured is not a prohibited transaction. Department of Labor exemption (PTE 92-6, amended 8/30/02)

The “fair market value” of a whole life policy where cash value equals reserve value may still be the cash value.


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Examples of Sale of Policy

Life Insurance with cash value of $200,000

Fixed Annuity with $350,000 value

412(e)(3) Plan Plan Transfers Policy

Individual Participant

$200,000Cash transferred to Plan


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After Sale of Policy

Fixed Annuity with $550,000

412(e)(3) Plan Individual

Life Policy with $200,000 of cash value

This plan can be rolled-over or used to provide monthly income


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Example of Life Policy Distribution

Assume a $1,000,000 face amount Whole Life Legacy 65 policy distributed to participant with a cash value of $711,292.

Assume a loan and dividend withdrawal of $284,517 to pay Federal and State taxes.


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Performance of Policy After Loan to Pay Income Taxes

Based on previous assumptions, current dividends and

policy loan interest of 6%, the policy will have the

following values:

Age Net Cash Value Net Death Benefit

80 $954,335 $1,500,753

90 $1,401,840 $1,818,863

100 $1,825,180 $1,825,180

The following examples are all based on the current rates of the MassMutual Odysseysm Annuity and Pension Whole Life Legacy 65 (paid-up at 65) which are not guaranteed. The Guarantees are subject to the claims-paying ability of the issuing companies.


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IRS Guidance-Impacting 412(e)(3) Plans Issued February 13, 2004

Rev. Ruling 2004-20

Rev. Ruling 2004-21

Proposed Regulation (Reg. 126967-03)

Revenue Procedure 2004-16


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Revenue Ruling 2004-20

Two (2) Fact Patterns Deemed Abusive:

1) Funding of Contracts is greater than plan benefits through normal retirement age

2) Life insurance contract in plan in excess of death benefit provided by plan


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Revenue Ruling 2004-20 (Cont’d)Fact Pattern 1

The first fact pattern simply and clearly holds that the plan will not qualify as a 412(e)(3) Plan. The funding must be assumed level through normal retirement and not five (5) years or other arbitrary time period


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Cost of life insurance owned by plan in excess of plan death benefit is non-deductible

Measure of deductible amount is total premiums less cost of “excess” life insurance protection based on 2002-8 “Split Dollar guidelines”


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Non-deductible contributions subject to excess tax of Sec. 4972 (10% per year)

Plans in which excess death benefit exceeds $100,000 are “listed transactions” under Treas. Reg. 1.6011-4(b)(2).


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TD 9223 Final Regulations

Final regulations clarify that when a life insurance contract is distributed from a qualified plan, the policy's fair market value (i.e., policy's cash value plus the value of all rights under the contract, including any supplemental agreements thereto and whether or not guaranteed) is generally included in the distributee's income, and not merely the entire cash value of the contract.

Little guidance on definition of Fair Market Value Fair Market Value in excess of amount paid is a Plan

distribution, and could in certain circumstances disqualify the plan


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Revenue Ruling 2004-21

Discrimination in life policies offered will violate 401(a) and disqualify plan

Applies to any rights, benefits or features


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Does GATT Effect 412(e)(3) Plans?

The Retirement Protection Act of 1994 (a part of the GATT Legislation) limited the maximum lump sum payable with its own specified interest rate and mortality.

Under most circumstances the “GATT” rate will result in a reduction of maximum amount that can be paid in the form of a lump sum.


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Overfunding

The practical effect of this is that a §412(e)(3) plan may become overfunded.

If a termination occurs when the plan is overfunded, the excess assets are taxable to the employer and the plan could face tax penalties of as much as 50%.


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Strategies to Avoid Overfunding

After the 412(e)(3) plan has been in effect for several years, the plan can be converted to a “regular” defined benefit plan.

This will mean having an enrolled actuary and complying with the funding limitations.


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Strategies to Avoid Overfunding

The plan post conversion will probably be “overfunded” and should come back in line with funding limits as years pass without contributions being made.

Fund to less than the maximum allowable benefit. If funded to 65% of maximum benefit the plan may avoid overfunding for lump sum distribution purposes.

Fund to age 65 and freeze Plan prior to age 65.


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Consider a Traditional DB Plan as an Alternative

The Plan can still have life insurance. No overfunding issues. Assets not limited to fixed annuities and life insurance. Life insurance for practical reasons limited to 100x the monthly benefit

Traditional DB Contribution ComparisonParticipant’s Age 52 412(e)(3) Plan* Traditional DB

Plan**Profit Sharing Plan

1st Year Contribution $138,307.83 $43,380 N/A

Maximum Contribution $49,000(2009)

*Assumes a life insurance/annuity combination limited by 74-307; a normal retirement age of 65 and an anticipated monthly benefit of $10,000**Assumes a 6% accumulation.


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“Carve Out Plans”

In general, Carve Out Plans are two separate plans established by the same employer/sponsor. Often one is a defined benefit plan and one is a defined contribution plan.


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Both Plans Must Pass Minimum Coverage Requirements of IRC Sec. 410(b) Ratio Percentage Test:

The plan benefits at least 70% of employees who are not highly compensated (“NHCE”); or

The plan benefits a percentage of NHCE that is at least 70% of the percentage of Highly Compensated Employees (“HCE”) benefiting under the plan

Average Benefits Test: Three part test Complex


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Examples of Ratio Benefits Tests

70% test IRC §410(b) (1) (A) 10 employees, 2 HCEs, 8 NHCEs Plan must benefit 70% of NHCEs under this test 70% x 8 = 5.6 – Plan must benefit at least 6 NHCEs


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Examples of Ratio Benefits Test

The relative percentage test-IRC §410(b) (1) (B) 15 eligible employees, 2 HCEs 13 NHCEs Assume only 1 HCE participates in plan (50% of

HCEs) Plan must benefit 70% of 50% of NHCEs 70% of 50% = 35% Plan must cover 5 NHCEs employees


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Additional Participation Requirement for Defined Benefit Plan

In addition to coverage tests outlined above, defined benefit plans including 412(e)(3) plans must meet the requirements of IRC §401(a) (26) that provides that a defined benefit plan must cover the lesser of 50 employees or 40% of all employees.


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Hurdles to Overcome for “Carve Out” Plans

Both plans must meet coverage tests under IRC §410 (b) Sponsor must have a non-discriminatory or have “business

reason” for dividing participants between the plans The defined benefit/412(e)(3) plan must pass IRC §401 (a)

(26) test (typically cover 40% of all employees)


49©2009 Massachusetts Mutual Life Insurance Company, Springfield, MA. All rights reserved. www.massmutual.com. MassMutual Financial Group is a marketing name for Massachusetts Mutual Life Insurance Company (MassMutual) and its affiliated companies and sales representatives

http://www.massmutual.com/

412(e)(3) Plans Beyond the Basics CRN201104-118361 For Producer and Professional Advisor Use Only. Not For Use With The Public.

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