Probably the #1 question I am asked is: what is the maximum contribution I can make to a defined benefit plan.
But a close second is: what is the minimum defined benefit plan contribution?
We all know about the large contributions that you can make with defined benefit plans (or cash balance plans). But what happens if you can’t fund your plan for a given year?
So why is funding such a a concern?
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Most clients expect the best case scenario, but they also know that life doesn’t always work out the way you want it to. People don’t want to feel “stuck” in a retirement plan that they can’t fund. For this reason, minimum contributions should be part of every set-up discussion.
The reality is that funding concerns are usually not as big a deal as you might think. This is because you have ways to structure the plan and other options to mitigate funding issues.
Table of contents
- What if I don’t have the money to fund the plan?
- #1 – Contribute at the low end of the range
- #2 – Adjust W2 compensation
- #3 – Remember the 1,000 hour eligibility requirement
- #4 – Don’t forget that 401k contributions are elective
- #5 – Freeze the plan
- #6 – Amend the plan
- #7 – Terminate the plan
- #8 – Examine Overfunding
- #9 – Break Up the Funding
- #10 – Pay the excise tax
- Final Thoughts
What if I don’t have the money to fund the plan?
Let’s assume you this has been a great year for your business and you are looking to make as large a contribution as possible. Of course, a large contribution makes the most sense in years when you are in a high federal and state tax bracket.
But you might be worried about next year. Maybe you are looking to reduce your hours? What if that large contract doesn’t renew?
The point is that you have concerns about the sustainability of those large contributions. This is a normal concern. We have often discussed that defined benefit plans are “permanent” plans. You just can’t make elective contributions whenever you want. This would not go over well with the IRS.
But situations do change. Business income can fluctuate from year to year. So, we want to take a look at a few strategies that you can consider in years when you are looking to make a minimal contribution (or even none at all).
#1 – Contribute at the low end of the range
When an actuary calculates annual funding, they will use many assumptions and estimates. These will result in a funding range. There is not one set amount that you are required to contribute.
In fact, the actuary will provide a target contribution. But this will also provide a minimum and maximum contribution. For example, your plan may have targeted funding in a given year of $80,000. But the range might be a minimum of $40,000 and $130,000 on the high end.
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This will give you a little discretion to make larger contributions in high income years and lower contributions in lean years. A wide funding range is typically not in place for the first plan year, but it widens as you gain more service years.
#2 – Adjust W2 compensation
If your business is structured as a corporation (either a C or an S), a large part of your contribution is determined by your W2 compensation. Your average compensation is what plays into your future benefit.
If your profit has gone down, then quite possibly your W2 compensation should be lower? Maybe your work hours are down? A decrease to your payroll will generally lower your funding range. But don’t forget that you are still required to pay yourself a reasonable wage under the law.
On an annual basis, corporations should do a compensation review with their CPA. This might be a good chance to revisit the topic.
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You might get lucky. If compensation for the current year is low and prior years have been overfunded, this could even result in no required contribution.
This is certainly not my first option, and you should discuss with your CPA. But I have seen situations in which there were payroll errors and paychecks made for periods in which services were not provided.
Make sure your payroll is accurate. If you find that your payroll was overstated, then it might make sense to go back and amend your payroll tax returns (Forms 941 and 940) to reflect a lower payroll.
#3 – Remember the 1,000 hour eligibility requirement
Most plans will have a set 1,000 hour eligibility requirement. So if you work less then that you will not be eligible for a contribution.
So make sure you consider how many hours you work in a given year. I recently had a physician who works on contract engagements out of state. Because of family concerns, she decided to take some time off and spend it at home. As a result, she will not likely meet 1,000 of work during the year.
So she would not have to fund for a year of service time. But there always is a small chance that she might have to make a contribution to fund the accrued benefit.
#4 – Don’t forget that 401k contributions are elective
Approximately 90% of the retirement structures we set up are “combo” plans. These combine a defined benefit plan with a 401k plan.
Most people are less interested in how much is funded in the different plans. They are just concerned with the overall funding amount.
So they may contribute $150,000 into the combined plans in a given year with the plan that would be the ongoing funding level. In reality, maybe only $120,000 is for the defined benefit plan with the difference being the 401k.
The nice part about the 401k plan is that the contributions are elective. This assumes it is a solo 401k plan. So the first thing to do is not fund the 401k plan which can help a lot when trying to hit minimum funding.
#5 – Freeze the plan
Freezing a defined benefit plan is a great option. But there are some pros and cons.
Once a plan is frozen, the employer still maintains responsibility for the plan and all filing requirements. This is because the plan is still in existence.
The biggest advantage to freezing a plan is that the plan does not have to continue to accrue benefits for employees. Years of service and benefit accruals are frozen.
The biggest disadvantage is that the employer must continue to pay ongoing administrative fees, including actuaries costs.
#6 – Amend the plan
The good news is that when you set up a plan you have the ability to amend it in subsequent years to allow for lower contributions (subject to certain conditions). You could actually lower the interest crediting rate.
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However, you are not allowed to reduce benefit amounts once employees have met eligibility requirements for the current year. Typically, eligibility is met upon working 1,000 hours during the year.
#7 – Terminate the plan
As we have discussed, the IRS assumes defined benefit plans are permanent plans. It is a plan adopted and executed by the business and contributions will be made on an annual basis (as required). But what does this really mean?
The basic assumption is that the plan is in place “indefinitely” or at least for a minimum of a “few years.” Unfortunately, the IRS has not always made it easy to interpret. They don’t specify what a “few years” means.
We know that each business situation is unique. The IRS has generally not questioned a plan termination when a plan has been in place for 5-10 years.
So there is no clear guideline. But your goal should be to have the plan open for at least 5 years. The IRS would like to see a “business necessity” if the plan is terminated.
If you plan to terminate the plan, make sure you do it before anyone becomes eligible in the current year. This is usually meeting the 1,000 hour rule. If you don’t terminate timely, you could be stuck making a contribution for the current year.
#8 – Examine Overfunding
Many people believe that defined benefit plans have annual funding requirements. While this is generally true, plans often become overfunded for a variety of reasons. This problem is common and, as a result, you may find out that you have no minimum funding amount.
So how does this happen?
Usually it is because of previous high funding levels. But it could be the result of huge account gains. But in either case, this is a good problem to have if you are looking to make minimum contributions during a given year.
So check with your TPA. You may get lucky and find out that there is no funding amount required in the current year.
#9 – Break Up the Funding
Here is a trick that can work very well in certain situations. Your defined benefit plan has to be funded by the deadline of 8 1/2 months after the plan year-end. For a calendar year plan, this is September 15th.
Most people want to make a contribution before filing the tax return for the prior year to take the tax deduction on the prior year return. This accrual basis makes more sense than cash basis. Both are allowable, subject to certain limitations.
But let’s say you have not fully funded your minimum defined benefit plan contribution, but you want to get your taxes filed. You can go ahead and file the return and then make the remaining contribution before the September 15th deadline.
Here is the best solution to this problem if you don’t want to make the extra contribution now and you want to get your taxes filed. You go ahead and file the tax return with only the $100k contribution. Then you make the extra $53k contribution before September 15th (the date all contributions have to be made). You then take this $53k as a tax deduction on your 2023 tax return. We can then amend your plan formula to be a flat $50k for 2023 so you will get yourself in line.
#10 – Pay the excise tax
OK so what happens if you have exhausted all other options and you simply can’t make the minimum contribution or you just don’t want to make a contribution at all. What happens next?
The result is that the IRS implies an excise penalty on the plan. But this might not be as bad as you might think.
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An excise tax is imposed on the company for a failure to meet the minimum funding required by the plan. The tax is calculated as 10% of the aggregate unpaid minimum required contributions. This calculation includes all plan years remaining as unpaid.
In addition, the IRS imposes an additional tax if the minimum funding requirements remain open for a specified period. So if you don’t make it timely you will want to catch up as soon as possible.
At the end of the day, having to pay the penalty may not be the worst thing especially if you have an immediate cash crunch. Unfortunately, the penalty is non-deductible.
Final Thoughts
Cash balance plans are increasingly popular. They offer significant tax deductions and the ability to supercharge your retirement. However, they offer some complications if the company desires to stop funding.
So if you find yourself trying to limit your contributions, make sure that you consider the above items. You should also communicate your concerns immediately to your third-part administrator (TPA) and CPA so that you understand your options. If you are proactive, your actions might be successful!
