# 412(i) Plan: What it Means, How it Works

## What Was a 412(i) Plan?

A 412(i) plan was a [defined-benefit pension plan](https://www.investopedia.com/terms/d/definedbenefitpensionplan.asp) that was designed for small business owners in the U.S. It was classified as a tax-qualified [pension plan](https://www.investopedia.com/terms/p/pensionplan.asp), so any amount that the company contributed to it could immediately be taken as a tax deduction by the company. The employee could also deduct their contributions. Guaranteed annuities or a combination of [annuities](https://www.investopedia.com/terms/a/annuity.asp) and life insurance were the only things that could fund a 412(i) plan. The 412(i) plan was replaced by the 412(e)(3) plan after December 31, 2007.

### Key Takeaways

*   A 412(i) plan was a defined-benefit pension plan that was designed for small business owners in the U.S.
*   A 412(i) was a tax-qualified benefit plan, meaning the company's contributions to the plan became a tax deduction for the company.
*   Guaranteed annuities or a combination of annuities and life insurance were the only things that could fund the plan.
*   Due to tax avoidance schemes that were occurring under 412(i), the Internal Revenue Service (IRS) replaced it with 412(e)(3).

## Understanding a 412(i) Plan

Notably, 412(i) plans were developed for small business owners who often found it difficult to invest in their company while trying to save for employees' retirement. The 412(i) plan was unique in that it provided fully guaranteed retirement benefits.

Insurance companies backed and offered the 412(i) plans to employers, and only insurance products like annuities and life insurance policies could be held in the plan. Contributions to it provided large tax deductions.

An annuity is a financial product that an individual can purchase via a lump-sum payment or installments. The insurance company, in turn, pays the owner a fixed stream of payments at some point in the future. Annuities are primarily used as an income stream for retirees. 

Due to the large [premiums](https://www.investopedia.com/terms/p/premium.asp) that had to be paid into the plan each year, a 412(i) plan was not ideal for all small business owners. The plan tended to benefit small businesses that were more established and profitable.

For example, a small business that had reached a stable, mature, and profitable state would have been better positioned to create a 412(i) plan than a bootstrapped startup or one that had only recently received [angel](https://www.investopedia.com/terms/a/angelinvestor.asp) or seed funding.

These companies also often don't generate enough [free cash flow](https://www.investopedia.com/terms/f/freecashflow.asp) (FCF) to put away consistently for employees’ retirement. Instead, the founding team members often re-invest any profits or outside funding back into their product or service to generate new sales and make updates to their core offerings.

## 412(i) Plans and Compliance Issues

*   In February 2004, after noticing abuse and tax avoidance issues involving life insurance policies held in retirement plans such as the 412(i), the [Internal Revenue Service](https://www.investopedia.com/terms/i/irs.asp) (IRS) issued guidance to shut down these tax avoidance schemes. Specially designed life insurance policies for high income employees with a 412(i) plan were the focal point of the abuse.

## 412(e)(3)

Due to the abuses of the 412(i) plan resulting in tax avoidance schemes, the Internal Revenue Service (IRS) moved the 412(i) provisions to 412(e)(3), effective for plans beginning after December 31, 2007. 412(e)(3) functions similarly to 412(i), except that it is exempt from the minimum funding rule. According to the IRS, the requirements for 412(e)(3) are as follows:

*   Plans must be funded exclusively by the purchase of a combination of annuities and life insurance contracts or individual annuities,
*   Plan contracts must provide for level annual premium payments to be paid extending not later than the retirement age for each individual participating in the plan, and commencing with the date the individual became a participant in the plan (or, in the case of an increase in benefits, commencing at the time such increase becomes effective),
*   Benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by an insurance carrier (licensed under the laws of a state to do business with the plan) to the extent premiums have been paid,
*   Premiums payable under such contracts for the plan year, and all prior plan years, have been paid before lapse or there is a reinstatement of the policy,
*   No rights under such contracts have been subject to a security interest at any time during the plan year, and
*   No policy loans are outstanding at any time during the plan year

> **Article Sources**
>
> 1.  Association of International Certified Professional Accountants, Journal of Accountancy. "[The Section 412(i) Retirement Alternative](https://www.journalofaccountancy.com/issues/2003/sep/thesection412iretirementalternative.html)."
>     
> 2.  Internal Revenue Service. "[Fully Insured 412(e)(3) Plans](https://www.irs.gov/retirement-plans/fully-insured-412e3-plans)."
>     
> 3.  Internal Revenue Service. "[Employee Plans Abusive Tax Transactions](https://www.irs.gov/retirement-plans/employee-plans-abusive-tax-transactions)."