Should Clients Buy Life Insurance in 412(e)3 DB Plans?

            Answer the following question: if your clients could invest $100,000 and let it grow for 20 years where at the end of 20 years the amounts equaled the following, which one should your clients purchase?

            Investment A after 20 years = $200,000
            Investment B after 20 years = $300,000

            Of course the answer is B. Why? Because both investments cost the same amount and after 20 years, B was worth $100,000 more. The decision is a no brainer.

            Answer the following question: If a business owner could take a deduction using life insurance in a qualified plan that is $150,000 a year vs. a plan with NO life insurance where the deduction is $100,000 a year, which one would the affluent business owner choose? 

            Of course, the answer is the plan WITH life insurance as an investment because the deduction is larger

            Answer the following question: If the qualified plan with the $150,000 deduction generated the SAME retirement income as the one with a $100,000 deduction, which plan should you as the advisor recommend?

            The answer is the one with a $100,000 deduction.

           Purchasing Life Insurance in a Qualified Plan

            If you have a life insurance license, the chances are significant that you have been solicited by a major insurance company, IMO,FMO,GA, etc. to have you pitch profitable small business owners 412(e)3 defined benefit plan funded 50% with life insurance.

            What is a 412(e)3 DB Plan? It is a qualified retirement plan that, by law, has to be funded with life insurance or annuity contracts. With a 412(e)3 DB (or non-412(e)3 DB plan), the EMPLOYER is funding the retirement plan to provide a specific retirement benefit for the employees at a specific retirement age. The retirement benefit is based on assumed growth rates on the money invested in the plan. The lower the assumed rate of return on the investment when the plan is setup, the more the employer must contribute to be able to provide the guaranteed retirement income for employees. Therefore, most advisors will use a very low assumed rate of return on the investments 2-3% to “jack-up” the deduction. Also, the closer a client is to retirement, the more money needs to be contributed to the plan.

            How is a 412(e)3 plan different from a 401(k)/PSP? With a 401(k)/PSP, money from the employer and/or employee goes into the plan where it is allowed to grow to any level (no restriction on growth) and can be used for retirement purposes by vested employees. So, if a 401(k)/PSP was funded for employee X and the account value of his/her money grew at 12% a year, the employees would vest and be able to use ALL of that money in retirement. With a 412(e)3 DB plan, if the returns on investments in the plan exceed the assumed rate of return, the future contributions of the employer would be lessened and the guaranteed retirement income would not change.

            Why do clients use 412(e)3 plans? Because with the right demographics of a small business, 412(e)3 plans allow for the largest corporate deduction into a qualified plan for the owner(s).

            Why does life insurance (LI) help create a larger deduction? The simple answer is because a LI policy inside a qualified plan where the gains will be taxable is NOT a good investment (insurance loads). Further, by funding 50% of the annual contributions into a life insurance policy (vs. annuities), the assumed rates of return are driven down and therefore, the required contributions are driven up.

            Let’s get back to the initial question. “Would you or your clients rather buy investment A or B”? The answer is B and you don’t even have to think about it.

            The following is a typical sale’s pitch of a 412(e)3 DB with LIFE INSURANCE to a mythical Dr. Smith age 55, who makes $700,000 a year and is looking for the largest possible qualified plan contribution. Assume Dr. Smith has a $3,000,000 life insurance policy in an irrevocable life insurance trust (ILIT).

            Advisor: Dr. Smith, as we have discussed, you can deduct this year through your business the following amounts depending on the various plans.



Regular DB Plan


412(e)3 DB Plan


412(e)3 DP Plan with 50% life insurance


            Dr. Smith: Wow, I like the $324,000 contribution plan. That’s the best one for me isn’t it?

            Advisor: Yes, the 412(e)3 plan funded with 50% life insurance is the best plan to receive the largest deduction.

            Dr. Smith: Great, let’s implement that plan.

            What was wrong with the sale’s pitch (understanding that it is much abbreviated for this newsletter)?The advisor did NOT talk about the retirement benefit.

            What if the advisor would have said the following:

            Advisor: Dr. Smith, I want you to know that whether you fund a regular DB plan, 412(e)3 DB plan, or 412(e)3 plan funded with life insurance, your retirement benefit will be the same.

            Dr. Smith: I don’t understand; I would be contributing $166,000 more into the last plan listed than the regular DB plan. Why don’t I receive more money in retirement?

            Advisor: The plan is regulated and has a maximum limit for how much you can accumulate in the plan for retirement. No matter how much you put into the plan, your retirement benefit will be the same.

            Advisor: So, Dr. Smith, which one of these plans would you like to use to receive your maximum retirement benefit?

            Dr. Smith: I think I will go with the regular defined benefit. I know the contribution is less, but the retirement benefit will be the same and I can use the other money not contributed to benefit myself in other ways.

            Dr. Smith: Advisor, can you help me find more deductions through my company as I now have an extra $166,000 to deduct if you can find plans that will benefit me?

            What am I trying to get across with the above? I’m trying to illustrate that most advisors sell 412(e)3 plan incorrectly and that nearly ALL insurance companies pushing this concept educate advisors incorrectly. The plan is sold on the deduction NOT on the retirement benefit. Why? The honest answer is because an advisor wants the large deduction and really wants 50% of the contributions to flow into a life insurance policy because the commissions will be maximized.

            Isn’t there a place for selling life insurance in a 412(e)3 plan or any qualified plan for that matter? This is the million dollar question I get from most life insurance agents. The answer is yes. It is appropriate to buy life insurance in a qualified plan IF the client does not have an estate-tax problem. Why? When buying life insurance in a qualified plan for someone with an estate-tax problem you are nearly guaranteeing the death benefit will be estate-taxed. When an employee dies while a life policy is in a qualified plan (assuming an estate-tax problem), the death benefit from the qualified plan will be estate taxed(without discussing the complicated sub-trust technique).

            Are there other problems with purchasing life insurance in a qualified plan? Sure, when the client wants to retire, what do you do with the policy? It can NOT be rolled over to an IRA. The life policy could be distributed to the employee and then gifted to an ILIT or an ILIT could buy the policy from the qualified plan, but doing so requires a lot of planning and is very expensive.

            How should advisors sell 412(e)3 plans? Advisors should sell 412(e)3 plans on the retirement benefit not the deduction.


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