You are probably aware of the powerful retirement planning strategies offered by cash balance plans, defined benefit plans and other pension structures. But are you aware of the defined benefit plan excise tax?

In this guide, we will discuss excise tax penalties and also address what is commonly referred to as reversion.

But don’t get too concerned because there are a few strategies that can be used to mitigate the problem.

If a company maintains a qualified plan along with a defined benefit plan, the rollover is subject to an excise tax of 20%, rather than 50%, of the amount reverted company’s qualified plan.

Some background

When most people set up a pension plan they don’t think much about overfunding issues. But when you consider volatility of the stock market and the flexibility of investment types, many people find that their plan is overfunded at some point down the road.

Let’s take a look at an example. Assume that a physician set up a solo defined benefit plan several years back. The accrued benefit that the physician has earned is $600,000.

But the investment account balance is actually $1 million. This is $400,000 over the amount the physician has earned and the plan is now considered overfunded by this amount.

This overfunding can happen for a variety of reasons. A typical cash balance plan will have an interest crediting rate of around 5%. But if the plan was invested in many speculative stocks, it may have had a return in a given year of 20% or maybe 50%. What if it had a 100% return and the assets doubled in a year?

I think you get the picture. The investment returns at some point may far exceed the amount that is allocated to the employees. This creates a big problem when the plan is ready to be terminated.

So how does the excise tax penalty work?

So let’s go back to the above example. The physician’s plan is overfunded by $400,000. What happens now?

There are many ways to get around this issue that we discuss here. We won’t go into detail in this post. But let’s assume you have exhausted all mitigation strategies.

It turns out the overfunded balance is assessed an excise tax penalty of 50%. It doesn’t end there. The overfunded portion is then subject to income tax as well. In addition, you cannot take a tax deduction for the excise tax penalty.

So at the end of the day, you will normally end up with zero to 10% of the overfunded balance. Doesn’t sound too fair!

What is reversion?

This issue is commonly referred to as reversion. But reversion aside, you need to also consider time value of money issues. If the plan continues to earn a return on investments, the reversion or overfunded portion will often become bigger.

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Very often people leave their funds in a cash account and fail to get a reasonable return on planned assets because any significant return will just magnify the overfunding problem.

Pension plans require a proactive approach. On an ongoing basis, the owner and the administrator should monitor the plan on a termination basis. This is crucial for a solo plan with just one owner who is nearing retirement.

Even if the owner has not been aggressive with funding, the assets can often exceed the accrued benefit for a plan that has existed for many years. If there is a spike in investment returns in a given year, the plan can quickly be overfunded.

As long as the owner is two to three years away from retirement, the solution to the overfunding issue can be to lower or eliminate contributions for the remaining plan years.

But if assets sharply increase during the plan’s final years, it might make sense to moving the assets out of equities and into less volatile investments.

So how does it work?

Upon the pension plan termination, any reversion of plan assets to the employer will be subject to an excise tax that is equal to 50 percent of the reversion amount, unless the employer either:

provides pro-rata benefit increases under the plan being terminated;
establishes or maintains a qualified replacement plan; or
does both (1) and (2), in which instance the excess tax is reduced to 20 percent of the reversion amount, provided that certain specified conditions (described below) are satisfied.

The excise tax is paid by the company maintaining the plan at the time of its termination. The excise tax is due by the last day of the month following the month in which the employer reversion occurs.

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The excise tax paid is not in place of any federal income taxes otherwise applicable to the reversion. It is a return of deductible contributions the employer made to the plan before the plan’s termination.

The excise tax penalty does not apply to an employer in bankruptcy liquidation under Chapter 7 of Title 11 of the United States Code or similar proceedings under state law. The 20 percent excise tax applies instead, regardless of whether the employer provides pro-rata benefit increases in the terminating plan or establishes or maintains a qualified replacement plan.

Excise penalty tax return

The tax is paid with Form 5330, Return of Excise Taxes Related to Employee Benefit Plans. At the rate determined under Code Section 6621, interest is charged on any tax not paid by the due date, even when an extension has been filed.

A penalty of 5 percent of the unpaid tax for each month or part of a month that the return is not filed by the due date, including extensions, may be assessed up to a maximum amount of 25 percent of the unpaid tax. This penalty will not be imposed due to reasonable cause shown in an attachment to Form 5330 explaining the reason.

Failure to pay the excise tax will result in a penalty of ½ percent of the unpaid tax balance for each month (or part thereof). The tax penalty is up to a maximum of 25 percent of the unpaid tax. This penalty is not assessed if the failure to pay is due to reasonable cause.

How to avoid the excise tax

The 5 steps to avoid or mitigate the excise tax:

Proactive actuary discussions
The actuarial calculations and overfunding will be noted on the Schedule SB. However, this schedule is challenging for companies to understand. That’s why every company should have an annual review of their plan with their actuary to make sure that underfunding or overfunding issues are addressed.
Review your investment profile
Remember that defined benefit plans usually have a stated interest rate around 5%. You don’t need to exactly hit this number. But you do need to minimize volatility. The YouTube video above does a good job of discussing the issue.
Complete a 5 year plan
Take a close look at your estimated funding levels and employee compensation over the next 5 years. That way you can get in front of funding complications and make sure your expected headcount is in line with your anticipated contributions.
Determine if you should freeze your plan
This usually makes more sense with an underfunded plan. But if you think overfunding will be an issue, make sure you discuss freezing options with your TPA or actuary.
Consider a plan amendment
Many companies fail to realize that they may be able to modify or amend their plan to address funding levels. Your CPA can assist with this process because of the sizable tax deduction issues.