For business owners with a defined benefit plan, funding ranges provide crucial flexibility in how much they can contribute to the plan each year. However, many business owners have questions about how these ranges work and whether they can predict future contributions.
In this article, we’ll explain how funding ranges are calculated, how they change over time, and how you can influence them to suit your financial goals.
Understanding funding ranges, including minimum, target, and maximum, can be challenging for many. But we always recommend that the client fund at the target or recommended amount to limit any underfunding or overfunding.
This post summarizes the discussion that we had on our podcast recently. Take a look at the YouTube video below:
What Is a Funding Range in Defined Benefit Plans?
In a defined benefit plan, the funding range is the spectrum of contributions you can make in a given year. Your plan’s actuary typically provides you with three key amounts:
- Minimum Funding: The lowest amount you must contribute to stay compliant with IRS requirements.
- Target Funding: The recommended amount that balances your current needs and future obligations.
- Maximum Funding: The highest amount you’re allowed to contribute under IRS rules.
Each year, as long as you contribute within your funding range, your plan remains compliant. The range provides flexibility to adjust contributions based on your business’s financial health.
How Are Funding Ranges Calculated?
An actuary calculates your funding range based on several factors, including:
- Your current income and age.
- Your target retirement benefit (how much you want to receive in retirement).
- Your plan’s expected investment return, typically set around 5%.
- IRS guidelines on contribution limits.
These variables help determine the minimum, target, and maximum contribution amounts for your DB plan. The IRS allows overfunding up to a certain limit, but exceeding that can reduce your ability to contribute in future years.
Minimum, Target, and Maximum Funding Amounts
To understand how these amounts work in practice, let’s look at an example. Suppose your actuary calculates the following funding range for a given year:
- Minimum: $100,000
- Target: $125,000
- Maximum: $200,000
This means you can contribute any amount between $100,000 and $200,000 and still meet the plan’s requirements. The target is the recommended contribution amount, balancing the present needs with future funding obligations. Funding at the maximum will reduce your future contributions but allow you to take advantage of tax deferral now.
Funding at the minimum allows you to preserve more cash flow for other needs in a low-income year but may require higher contributions later. On the other hand, funding at the maximum reduces your future flexibility, as you’re essentially frontloading your contributions and pulling from future obligations. Overfunding now means you won’t need to contribute as much in subsequent years, but it also limits your flexibility if you need more tax deferral later.
The Role of Investment Returns in Funding Ranges
Your plan’s expected investment return plays a big role in determining your future funding needs. Most plans assume a 5% annual return, but actual returns can vary widely. If your investments underperform, you may need to contribute more in future years to make up the difference. If they overperform, you may be able to reduce your contributions.
One of the reasons we avoid providing long-term funding estimates is that there are too many uncontrollable variables. For example:
- Market performance: Your actual investment returns may differ from the assumed 5%, impacting how much you need to contribute.
- Income fluctuations: If your income changes from year to year, your funding requirements will also change.
- Life events: A bonus, job change, or even a spouse’s income can affect your tax bracket and funding needs.
Given these factors, trying to predict funding ranges two or three years into the future is often unreliable.
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How to Influence Your Funding Range
While some aspects of your funding range are determined by external factors, there are several ways you can adjust your funding range to better suit your needs:
- Adjust Your W-2 Income: Your W-2 salary directly impacts your contribution limits. By increasing your W-2 income, you can raise the maximum amount you’re allowed to contribute to the DB plan. However, be mindful of what qualifies as a reasonable wage, as required by the IRS.
- Include a Spouse: Adding a spouse to the plan can increase your contribution limits, particularly if they work for the business.
- Modify Benefit Formula: Your DB plan’s benefit formula can be adjusted to increase or decrease the contribution limits, providing more control over your annual funding range.
Adjusting W-2 Income to Maximize Contributions
The IRS allows you to contribute up to $275,000 in W-2 income for DB plan purposes. If you’re currently paying yourself $200,000, raising your W-2 salary to $275,000 can increase the allowable contributions to your DB plan. This strategy is particularly useful if you want to frontload contributions and reduce taxable income.
Understanding the IRS Limits on Overfunding
The IRS discourages overfunding DB plans, and any contributions above the maximum allowed will affect future contributions. Overfunding one year pulls from future contributions, reducing how much you can contribute in later years. This is why careful planning is essential to maintain balance.
Real-Life Example: Controlling Your Funding Range
Let’s say you’re a 56-year-old business owner, and you want to consistently contribute around $100,000 each year to your DB plan. Currently, your actuary suggests you could contribute up to $200,000. By adjusting your plan’s pay credit percentage or benefit formula, you can lower your future contributions to ensure a more manageable funding range that aligns with your long-term financial goals.
Because funding ranges can be complex and influenced by multiple factors, it’s important to maintain regular communication with your TPA or actuary. By working together, you can adjust your plan based on your business’s financial performance and any personal changes that may affect your contribution needs.
Key Takeaways
Funding ranges provide significant flexibility in how much you can contribute to your DB plan each year, allowing you to adjust based on income, market performance, and other factors. However, overfunding can limit future contributions, so it’s essential to strike the right balance. By understanding the factors that influence your funding range, you can maximize contributions while maintaining long-term flexibility.
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