Cash balance plans can be complex. Each year, the plan sponsor will be given a target funding level. But they will typically receive a minimum and maximum level as well. So they have a range to choose from. As a result, there can be problems with underfunded and overfunded cash balance plans.
The minimum required contribution is determined using IRC rules. The rules are designed to ensure that once a defined benefit plan is set up, the plan sponsor will fund such that there will be a high likelihood that there are enough assets accumulated in the plan to pay benefits to the participants when due.Are you looking to get over $100,000 into retirement? Get a FREE Illustration showing your contribution and tax savings today. See for yourself why our plans are one of the best tax deferrals!
The minimum contribution amount is determined annually. It is documented on the Form 5500 Schedule SB for single employer plans (or Schedule MB for multiemployer plans).Quick Navigation
- Underfunded cash balance plan
- Overfunded cash balance plan
- How does a cash balance plan become overfunded
- Terminating an overfunded cash balance plan
- How to correct an overfunded plan
Underfunded cash balance plan
The maximum tax-deductible contribution is also determined using IRC rules. The point is to allow flexibility for the plan sponsor to make large contributions in good business years to accumulate funds when they have cash flow.
This maximum contribution level is limited because tax deductions for retirement plan contributions are a direct reduction in tax revenue, and the federal budget requires income and expense to be in line. The maximum contribution limit is determined annually and is typically documented in the actuarial valuation report.
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A plan sponsor that contributes the minimum each year could find that the plan’s funding level is too low. This can cause the minimum contribution to rise substantially each year.
If the funding level falls below specified thresholds, the plan could be subject to benefit distribution restrictions. For this reason, the plan sponsor may target a higher contribution level than the minimum to avoid running into problems.
Overfunded cash balance plan
Also, funding levels are shown on the employer’s financial statements and plan financial statements. Loan covenants, certain types of insurance and other business relationships could be undermined in the event of a funding level that is too low.
As a result, the plan sponsor may want to make contributions higher than the minimum and higher than what is necessary to avoid benefit distribution restrictions.
The actuary or benefits consultant should discuss the funding objectives with the company. There should be a documented funding strategy that is intended to apply year after year. This will give the company an expectation to meet.
An example of a suggested contribution level could be as simple as contributing the minimum required contribution plus 6% of payroll (where the additional contribution above the minimum allowing for some extra funding to help ensure that benefits can be paid, and any restrictions on distributions will be avoided).
There are ways to determine a suggested contribution, such as using an actuarial method of calculating contributions other than what is required for minimum funding. These methods are considered to be outside the scope of this course and should be determined only upon consulting with an enrolled actuary.
How does a cash balance plan become overfunded
On an annual basis, the plan actuary will calculate the amount to be contributed. This is done based on the planned participant benefits and the interest crediting rate. Since this is a qualified plan, the contributions are a tax deduction for the employer.Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!
The balance in the plan account at any point in the year depends a few factors, including any amounts paid to participants and the earnings on the plan investments (interest, dividends, capital gains, etc.).
As a result, changes in the market can cause a plan to be underfunded or overfunded. This is actually pretty common. The overfunding itself will not change participant benefits and the business owner cannot take it out.
Terminating an overfunded cash balance plan
There are many examples of underfunded cash balance plans and many have made the news headlines. So one would assume that being overfunded would be a great thing.
But this is not the case. The funds cannot just be taken out of the plan until the plan itself is terminated. This will normally happen when the owner retires or decides to sell or otherwise dispose of the business.
When an overfunded plan is ultimately terminated and liquidated, the company would pay an excise tax on the excess funds because the contributions were tax deductible. The overfunded balance is subject to the 50% excise tax. Unfortunately, this tax is non-deductible.
The tax itself was established back in 1986 as a way to combat corporate raiders from liquidating pensions, paying out minimum benefits and keeping the rest for themselves. So there were good intentions.
The law was aimed to protect large corporations, but the tax is applicable to all cash balance plans (large and small). Without careful planning, small business owners can find themselves paying the 50% excise tax and then an additional 40% if funds are withdrawn and not rolled over to another retirement plan. A 90% tax is quite a hit.
How to correct an overfunded plan
There are many ways that TPAs and financial advisors can help companies correct overfunded plans. Depending on how much the plan is overfunded, there are many options to consider. This is where the company needs to make sure that they work with experienced professionals.
Enhance Existing Retirement Benefits
The company may use the surplus funds to maximize the current plan benefits without significantly changing actuarial assumptions or benefit formulas. A certain amount or percentage of salary can be allocated to participants within the existing plan structure. This would enable the participants to receive larger benefits at retirement.
Match 401(k) Contributions
Overfunding can is some situations be used to match employee contributions to a 401(k) plan. The funds need to reside in a “sub-account” in the cash balance plan and not be contributed to the employee account.
Include Family Members as Participants
For small, closely held companies this can be a great option. The company can add family members as plan participants. Because the plan is overfunded, additional funds do not have to be contributed to the plan. The benefits will get allocated to family members and can avoid excise tax. But make sure you discuss the issue with the TPA and your accountant.
Consider Including Insurance
Businesses can use overfunding to buy life insurance. There are certain limitations and specific rules when using life insurance in a plan. The first step is to amend the plan document to allow for the change.
When plans get substantially overfunded, fixing the overfunding can be more challenging. One option can be to sell the company to another company that has an underfunded plan. After the purchase, the plans could be merged and the overfunding in one plan can offset the the underfunding in another.
In some situations, companies that been near bankruptcy with overfunded pension plans have used this strategy with great success. The sale may allow them to get more money for the company. But this is more challenging for small family owned companies.
Business acquisitions have been helped by the IRS with recent rulings. The goal of course is that the merger of the plans should not trigger current federal or state income tax and also avoid excise tax. Profits from the transaction are still taxed as capital gains, which is still less than the excise tax.
Maintain the plan until funding gets back in line
If a sale is not desired, the company can carry on with the business and not fund the plan. The plan will still stay in place, but with add’l years of service the funding may get back in line.
- Amend the plan to increase benefits. The business can possibly amend the plan to use the surplus funds to maximize current benefits. This may be done without making significant actuarial changes or benefit formulas.
- Employ family members. Assuming you have family members that can work in the business, this can be a great option. The benefits can get allocated to the family members and avoid the 50% excise tax.
- Purchase insurance. Companies can in some situations use overfunding to buy life insurance. There are certain restrictions and limitations.
- Consider a sale. The company could be sold to another company that has an underfunded cash balance plan. After the sale, the plans can then be merged.
- Maintain the plan with no funding. As long as the company is not going to closed, the company and plan can stay open and just not contribute add’l funds until the overfunding is corrected.