We get a lot of questions about the $3.7 million limit for cash balance plans and define benefit plans. Most clients don’t understand what this number means and how it is determined.
In this post, we will show you how the $3.7 million amount is calculated. In addition, we will dispel some myths and give you some planning strategies.
This topic is complex, but we simplify it. Let’s get started!
Defined Benefit Plan Background
Defined benefit plans differ significantly from defined contribution plans in structure. Defined contribution plans, like 401(k)s, focus on participant contributions and investment options. The final retirement benefit depends on contributions and investment performance.
However, defined benefit plans promise a specific “benefit” at retirement. These plans payout as an annuity stream or lump sum. Employers fund and manage the investments, taking on the financial risk to ensure promised benefits.
There is no limit to the amount you can have in a defined contribution plan. However, there is currently a $3.7 million per participant cap on the allowed balance in a defined benefit plan.
Now that you understand the basics of how these plans are structured, here are some typical questions that arise:
- At what age is the $3.7 million determined? Can it be at any age?
- Can anybody receive the $3.7 million or is it determined based on your compensation?
- Is the $3.7 million made up of just contributions or contributions plus investment returns?
- Is the $3.7 million amount adjusted for inflation?
- Is the applicable retirement age 59 1/2?
- Is the $3.7 million per person or plan total?
Let’s answer some of these questions below and dive into the details.
What Does the $3.7 Million Represent?
First of all, the $3.7 million is the maximum payout or distribution amount per participant at retirement. The limit often refers to the maximum allowable lump sum benefit that can be paid out to a participant upon retirement, based on IRS rules.
The limit is a combination of contributions and investment returns. In fact, it doesn’t matter whether you have mostly investment earnings and lower contributions or high contributions and lower earnings. It is simply a dollar cap.
Because the $3.7 million is per plan participant, if you had a plan with your spouse then each of you could potentially have $3.7 million (or $7 million in total). You would have to each meet the other criteria to qualify. But at least it is possible.
In addition, the $3.7 million maximum is for each person and each “control” group. Control groups are essentially businesses that you control or are affiliated with. You are then restricted to one $3.7 million for each control group.
This means that if you are a physician and you participate in a plan at the hospital you work at, you could also accumulate $3.7 million through you own business. So, it is possible for one person to have multiple $3.7 million amounts.
As a result of the control group rules, if someone wanted to have multiple $3.7 million amounts, they are unable to set up multiple LLCs or corporations and have multiple $3.7 million amounts. Because these businesses are under common “control,” they would all be combined together for just one $3.7 million maximum.
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Criteria to Meet the $3.7 Million Limit
But not every plan participant can receive the $3.7 million maximum. Here are the criteria you would need to meet:
- Retirement Age. You must be at least 62 years old.
- Compensation. You must have three consecutive years of W2 compensation of at least $290,000.
- Plan participation. You must have plan participation of at least 10 years.
Remember that conceptually a defined benefit plan is very similar to Social Security. Contributions are made throughout your lifetime and at retirement you’ll take an income stream for the remainder of your life. This is how both define benefit plans and Social Security works.
But there’s one difference between Social Security and a defined benefit plan. Social Security does not allow you to take a one-time lump sum payout. You can’t call the government on a given day and request that you opt out of Social Security and take the present value of your future benefits as a one-time amount. But when you terminated a cash balance plan, you’re allowed to take that one-time amount and roll it over into an IRA or other qualified retirement plan.
How Does the IRS Determine the Maximum?
The IRS determines the limit. The limit represents the lump-sum equivalent of the maximum annual benefit payments, calculated using actuarial assumptions. The Internal Revenue Code (IRC) §415 imposes limits on the benefit that can be paid out.
However, the IRS does not state the $3.7 million limit anywhere. You won’t find this number on their website or in any of their technical releases.
On an annual basis, the IRS publishes mortality rates, applicable interest rates, and other changes. They then calculate the maximum annual annuity stream that can be paid out at retirement age.
For 2026, the annual limit on benefits is $290,000. The IRS states that the plan can make an annual annuity payment of $290,000 from the designated retirement age through the participant’s expected life expectancy.
Is a Cash Balance or Defined Benefit Plan Right For You?
Actuaries use the IRS benefit payments to “back into” the $3.7 million amount. They take the IRS maximum payment stream and then discount it back to the retirement age to determine the maximum limit. Said differently, if you had $3.7 million at age 62, you could take out $290,000 annually over your expected remaining life.
Mortality tables also play a key role in lump sum calculations. These tables estimate life expectancy based on age and other factors. Longer life expectancies increase the total projected benefit, influencing the lump sum.
Can Anybody Qualify for the Maximum?
The short answer is no. You qualify, in part, for this amount based on your maximum compensation.
Most cash balance plans are structured to allow a maximum payout based on the highest three years. These are usually the last three years before you retire. But that does not have to be the case.
In order to qualify for the $3.7 million, you must have three consecutive years of W-2 compensation of at least $290,000. The maximum payout is prorated if you have lower W2 compensation levels.
For example, if you had three consecutive years of $145,000 then you would qualify for half of the $3.7 million, or roughly $1.85 million.
I often say that if you started a company today and you hired a CEO and paid this person $300,000 a year and also hired a janitor and paid them $30,000 a year, of course the CEO would earn a bigger retirement payout. The CEO might qualify for the $3.7 million, while the janitor could qualify for around $375k.
In summary, you need to have high enough W2 compensation (or self-employment income) to qualify for the limit. You can’t simply pay yourself minimum wage and then qualify for the maximum payout.
Is There an Age Requirement?
In order to meet the $3.7 million, you must have reached the retirement age of 62 or 65. In most situations, we structure plans using age 62 because that will typically allow higher annual contributions.
While you can terminate a plan before retirement age, the maximum amount will be adjusted downward based on a variety of factors. This means the lump sum will be lower for those retiring early.
Many people assume the retirement age for defined benefit plans is 59 1/2. This is not the case. Age 59 1/2 is the age when you no longer are assessed a 10% penalty for early withdrawal from retirement plans. But this date is independent of the defined benefit plan retirement age.
The table below illustrates the maximum payout by age if you terminated a plan early. It also assumes 10 years of participation. You can see the final payout at age 62.
| Age | Maximum Balance |
|---|---|
| 32 | $799,000 |
| 33 | $839,000 |
| 34 | $882,000 |
| 35 | $927,000 |
| 36 | $974,000 |
| 37 | $1,023,000 |
| 38 | $1,075,000 |
| 39 | $1,130,000 |
| 40 | $1,187,000 |
| 41 | $1,248,000 |
| 42 | $1,311,000 |
| 43 | $1,378,000 |
| 44 | $1,448,000 |
| 45 | $1,522,010 |
| 46 | $1,599,000 |
| 47 | $1,680,000 |
| 48 | $1,766,000 |
| 49 | $1,856,000 |
| 50 | $1,951,000 |
| 51 | $2,050,000 |
| 52 | $2,155,000 |
| 53 | $2,265,000 |
| 54 | $2,381,000 |
| 55 | $2,502,000 |
| 56 | $2,630,000 |
| 57 | $2,764,000 |
| 58 | $2,906,000 |
| 59 | $3,054,000 |
| 60 | $3,211,000 |
| 61 | $3,375,000 |
| 62 | $3,548,000 |
How Long Must a Plan be Open? 10-Year Requirement
In addition, many people think they may be able to contribute the maximum amount over just a few years. This is inaccurate.
One of the key components to the $3.7 million limit is the years of plan participation. In order to achieve the maximum, you need to participate in the plan for at least 10 years. If the plan is not open for 10 years, you’ll have to prorate the amount to determine the limit.
For example, if you only participated in the plan for four years, you would only be able to have approximately 40% of the $3.7 million, or roughly $1.4 million.
Is the $3.7 Million Adjusted for Inflation?
The good news is that the $3.7 million limit is adjusted annually for inflation. This ensures the limit keeps pace with rising costs. The IRS reviews and updates the limit based on cost-of-living changes each year.
As a general rule, the limit goes up approximately $100,000 annually. But it certainly can be more or less depending on inflation and other factors.
For example, let’s assume a 42-year-old established a plan when the limit was $3.7 million. With 20 years until retirement age of 62, you might expect that the limit would be around $5.5 million (20 years times $100,000 annually).
But with this higher limit comes higher compensation amounts. If this 42-year-old was paid $290,000 a year he would still only qualify for the $3.7 million. If you index the $290,000 compensation for inflation, the 42-year-old might be required to have three years of W-2 compensation of around $500,000. So, it’s important to remember that inflation adjustments not only impact the payout limit, but also the required compensation amount.
The process for adjusting limits follows IRS guidelines. Inflation adjustments are crucial to maintaining the value of retirement benefits. Without adjustments, retirees would face reduced purchasing power over time.
What if the Asset Balance Exceeds $3.7 Million?
So, why is it a big deal if your assets exceed $3.7 million? It’s because of IRS penalties and something called reversion.
Reversion happens when a business terminates an overfunded cash balance plan. The excess assets (or the overfunded amount) are reverted to the business. The business must pay tax on this amount as taxable income. It is then also subject to a 50% excise tax.
The combined federal and state tax would be around 40%. When you add the 50% excise tax, you would have a combined tax rate of around 90%. To worsen the situation, the business cannot deduct the excise tax.
If you reside in a state with high-income taxes, such as California, you could potentially lose the entire amount and even have to pay additional out-of-pocket expenses due to state income tax. Company owners must carefully plan. A 90% tax is quite a hit!
Final Thoughts
Defined benefit plans have a maximum lump sum limit tied to IRS regulations. Employers must carefully design plans to comply with these rules.
The $3.7 million lump sum is calculated using interest rates and mortality tables. These factors influence the benefit’s present value. Adjustments apply for early terminations.
In summary, the criteria to reach $3.7 million depends on various factors. Retirement age, years of participation, compensation, and mortality assumptions all influence this milestone. Understanding IRS rules and planning carefully can help achieve your financial goals.
