In the past you may have seenarticles indicating that a 412(i)defined-benefit plan is a terrificoption to deduct hundreds of thousandsof dollars from their incomeinto a qualified retirement plan forphysicians with high incomes. Whilethat may be true for a small group ofphysicians aged 50 and older, for themost part, a 412(i) plan is not agood option when looking forincome tax reduction. Becausethere's been some very aggressivemarketing of the 412(i) plan tophysicians around the country, physiciansshould be especially skepticalwhen someone pitches them a412(i) defined-benefit plan.
First, let's outline who is a goodcandidate to use a 412(i) plan. Verysimply put, any physician over the ageof 50 who has little or no money in aqualified plan (ie, profit-sharing plan,traditional defined-benefit plan,401(k) plan, savings incentive matchplan for employees, or simplifiedemployee pension plan) or an IRA isa good candidate. If you do not fitinto this category—hopefully youdon't—a 412(i) plan is not for you.
Then why are so many advisorspitching 412(i) plans to any doctorover the age of 40? easeand greed. Ease, because the topic iseasy to sell from a technical standpoint.The consultant can point tothe tax code and a client's CPA canread the code and approve the topic.Greed, because an agent can counsela physician to put hundreds of thousandsof dollars into the plan and,therefore, make sizable commissions.
Typically, a 412(i) plan uses mostlyannuities to guarantee investmentreturns. This aspect of the plan is differentfrom a 401(k) or profit sharingplan in that these plans do not mandatea set payout at the time anemployee retires. Traditionally, financialadvisors do not make muchmoney from annuities and, therefore,the topic is not that exciting. Today,however, companies are becomingvery aggressive with their planning,and some 412(i) plans are allowingclients to put 100% of their moneyinto a particular type of life insurancepolicy, what I call a "sponge" lifeinsurance policy. This kind of policy isrecommended to help specific investors(ie, those who have $1 millionor more in a qualified plan or IRA andthose who also have a $3-millionestate) avoid the double-taxation issueof money in a traditional qualifiedplan. The life insurance policy literallysucks up the money in a qualified planlike a sponge absorbs water, and isspecifically designed to have a lowcash surrender value (CSV) at the endof the fifth year. At this time (ie, end ofthe fifth year), the investor will purchasethe policy from the 412(i) planfor the low CSV and then wait atleast 5 years before accessing tax-freeloans from that life insurance policy.
In theory, this sounds like a goodstrategy. By following the numbers,you get a clearer picture. If aninvestor put $250,000 into a 412(i)plan each year for 5 years as a tax-deductibleexpense, they would havefunded $1.25 million over that 5-yearperiod. The CSV of the policy at theend of the fifth year is approximately$250,000. The client then purchasesthe life insurance policy from the412(i) plan for that $250,000 CSVand feels like they got a great dealbecause the cash account value(CAV) of the policy was really $1.1million. The client then waits for thesurrender charges in the life insurancepolicy to evaporate and takestax-free loans from the policy.
So, advisors pitch 412(i) plans asan options that allows an investor toput massive amounts of money awayin a tax-deductible manner and thenpurchase the life insurance policy,which has a low CSV but a high CAV.This seems like a steal of a deal, sincethe client only paid one fifth of thevalue of the asset when purchasing itout of the 412(i) plan. While the topicis slightly better than posttax investing,it pales in comparison to severalother topics in the marketplace. Thefollowing is an example.
Assume that a physician age 50with no employees deducts $250,000a year from their income for 5 yearsand puts it into a 412(i) plan, anotherphysician puts the same amountinto the ExTRA plan, another putsthe same amount into the accountsreceivable factoring plan, and yetanother puts the same amount intothe Equity Disability Trust. Assumethe benefit taken from each plan isfrom age 60 to 85. Following is a listof possible outcomes:
• 412(i) plan. The physician investorusing this plan could get anincome tax-free benefit of $116,552for 25 years starting at age 60.
• ExTRA plan. The physician investorusing this plan could get anincome tax-free benefit of $178,036for 25 years starting at age 60.
• Accounts receivable factoring.The physician-investor usingthis strategy could get an incometax-free benefit of $170,673 for 25years starting at age 60.
• Equity Disability Trust. Thephysician-investor who chooses touse this trust could get an incometax-free benefit of $143,000 for 25years starting at age 60.
This example completely ignoresthe fact that most physicians will haveemployees where the employer, inorder to implement a 412(i) plan, willhave to fund sometimes tens of thousandsof dollars into the 412(i) planto allow the key owner to contribute.
EXPECT A TWIST
Be aware that the 5 pay life insurancepolicies (sponge policies) typicallyused in 412(i) plans have noflexibility in payment. If you can't ordon't want to make a premium paymentto your 412(i) life policy, thereis no way to lower the internal lifeinsurance costs of the policy (withoutlosing substantial CAV). Thatmeans if the internal cost of insurancein the policy is $60,000 a yearfor 5 years and in year 3 you can'tpay a premium, there is no financiallyviable way to avoid paying that$60,000 annual premium. The premiumwill be paid internally fromthe CAV of the policy.
In my opinion, the 412(i) plan isthe most inflexible income tax reductionplan in the entire marketplaceand most investors that participatein a 412(i) plan have no idea ofthe plan's inflexibility.
Roccy DeFrancesco is an
attorney and author of "The
Doctor's Wealth Preservation
Guide." He has run a medical
practice and lectured for many
state and national medical
associations. For a free asset protection,
income, and estate tax reduction CD, or for
questions or comments, call 269-469-0537 or