A new generation of split-funded defined benefit plans can dramatically boost small-business owners’ retirement savings. These new tax-compliant plans, including The Hartford “Solo db Life,” and Pacific Life Insurance Company’s “Qualified Combo Plan,” court business owners with a maximum of 10 employees. The plans let owners contribute significantly more toward retirement than they might through traditional SEP IRAs, SIMPLE plans, 401 (k)s and profit-sharing plans.
With a split-funded defined benefit plan, a business owner makes tax-deductible contributions to a traditional defined benefit plan. Contributions can be split between investments and life insurance. A third-party administrator determines the amount needed to fund the split-funded plan, based on plan participant ages and salary history.
When the owner or employees retire or leave their jobs with vested benefits, plan distributions are made, or the defined benefit plan may be rolled over into an IRA.
“Split-funded defined benefit plans are for small-business owners who need life insurance and also need to accelerate funding toward retirement,” says Brian Murphy, executive vice president of The Hartford’s individual life insurance division. “The mutual funds and the cash value portion of the life insurance provide the funding for a future defined benefit. Since it is a qualified plan, contributions are tax-deductible.”
The typical owner should be at least 45 years old and earn more than $75,000 annually, Murphy says. Each year, the business owner must be able to contribute more than $46,000, or 25 percent of compensation, toward retirement; he or she should not expect to retire for at least seven years. The maximum amount that a 45-year-old businessperson who plans to retire at age 65 is permitted to put in a split-funded plan is $2.44 million, assuming a 5 percent rate of return. Based on IRS rules, that provides $195,000 in annual income to the business owner.
At The Hartford, a portion of the split-funded plan contributions can be invested in Hartford’s mutual fund family. A whole life insurance policy, embedded in the plan, offers a guaranteed level premium, cash value and a death benefit. The guaranteed crediting rate on the whole life insurance is 3 percent. The insurer currently pays 4.75 percent.
Hartford’s turnkey product includes plan documents, annual maintenance, statements showing each participant's accrued benefits and signature-ready forms for government compliance. The plan is administered by Plan Administrators, Inc., De Pere, Wis.
Mike Tinsley, Pacific Life vice president, cites a huge market for split-funded plans. There are an estimated 4 million small-business owners who may benefit from it. There also are 430,000 401(k) profit-sharing plans in small to mid-size companies eligible to participate. The best potential candidates are highly paid business owners, professionals, subchapter S corporations, independent contractors and small, closely held businesses.
Pacific Life’s product combines the use of a 401(k) profit sharing plan with a split-funded defined benefit plan. The plan’s universal life insurance policy currently pays more than 5 percent on the cash value. But small-business owners must hire their own third-party administrator for it.
“The combo plan enables business owners to accumulate significant retirement savings in a shorter period of time,” Tinsley said. “It cost-effectively meets the nondiscrimination rules for qualified plans. The contributions are tax-deductible and life insurance is provided with pre-tax dollars.”
These types of arrangements typically protect plan assets from creditors, and the life insurance may be portable, Tinsley adds. Plan participants, however, must report the current cost of the life insurance protection in the split-funded defined benefit plan annually as taxable income. But that cost, Tinsley says, is small compared with the total premiums.
If the plan participant dies, the plan provides the participant’s family with vested retirement benefits and a tax-free life insurance death benefit. The life insurance policy also can be sold to the participant or to his or her irrevocable life insurance trust for estate tax planning purposes. The policy purchase price is based on the life insurance policy’s fair market value.
Ray Berry, compensation and benefits director with Grant Thornton, Chicago, said that in the last year, a number of insurance companies have launched tax compliant split-funded defined benefit plans. Of course, there is no free lunch with the plans.
Registered reps and their small-business clients must conduct due diligence to ensure that the plans strictly adhere to IRS regulations. Otherwise, Uncle Sam might consider the split-funded plan an abusive tax shelter.
In the past, split-funded defined benefit plans have raised the ire of the IRS. The IRS already considers some types of setups, known as “412 plans,” abusive tax shelters. That’s because the plans were fully funded with life insurance, but did not meet nondiscrimination rules, which require that the owners make the plan available to employees. Even though business owners took big write-offs through those plans, the insurance policy’s cash value was lower than the cash value of a typical insurance policy.
Insurance premiums for the new generation of split-funded defined benefit plans need to be based on a series of factors. These include the insured’s current age, actuarial calculations based on a plan benefit formula, and the years of service and average compensation of an employee.
“The IRS is going to disqualify products that jump through hoops,” Berry warned. “It is best to hire counsel. “You have to look at the administrative costs and the cost to added employees to the plan.”
A split-funded defined benefit plan may not always be the best option. Both retirement income distributions from the investments and cash value withdrawals from the insurance policy are considered taxable income.
The amount of life insurance that may be held inside a qualified plan is limited, so a business owner may need to purchase life insurance outside the plan. At death, any benefit provided by the plan, including the life insurance death benefit, may be included in the participant’s taxable estate.
Also, the employer bears the investment risk for the split-funded defined benefit plan.
Jonathan Pond, a Newton, Mass.-based financial planner, said that properly managed tax-efficient investments combined with an income annuity may be a better option for some business owners.
“They (small-business owners) may not need the insurance because they are already well-insured,” he said. “The income distributed from the cash value of the plan’s insurance policy is taxable. Retirees would also pay ordinary income tax on the distributions from the investments, thus turning capital gains into ordinary income.”
