You likely understand that your defined benefit plan’s funding range includes a target contribution and a minimum and maximum. But what do these figures represent, and why are they significant?
It is critical to understand that your funding decisions in any given year will significantly influence your future funding. Each dollar you contribute today reduces the amount you can contribute later. This is why as plan administrators we strongly encourage our clients to fund at the target contribution level.
This article will discuss how maximum funding ranges are calculated. We will also point out the pitfalls of funding at the maximum. Let’s jump in!
Background
Funding ranges can be difficult to understand. For each year you have a defined benefit plan, you will be given a minimum, a target or recommended, and a maximum amount. But the implications of what this range means may not be crystal clear.
People who want to aggressively fund will often just select the maximum amount and make the contribution. But they fail to understand how this impacts their future contributions.
The IRS allows you to overfund your defined benefit plan by permitting a maximum contribution. However, this overfunding comes at a significant cost. If you fund the maximum, future contributions will decrease. Before discussing the details, let’s briefly review how target contributions work.
What is a Target Contribution?
Your target or “recommended” contribution is the amount needed to keep the plan funding on “target.” This amount keeps the plan from essentially being underfunded or overfunded.
It’s important to note that a defined benefit plan actually “defines” a benefit at retirement based on the plan formula. Each plan year, the actuary calculates this future benefit and then discounts it back to the end of the plan year.
The target contribution considers your age, compensation, and asset levels to calculate the amount needed to meet your retirement benefit. This target contribution is adjusted annually based on changes in these variables.
How do Maximum Contributions Work?
The IRS provides some funding flexibility for defined benefit plans. Fortunately, the IRS permits companies to contribute more than the required minimum or the target amount.
Why do they allow this extra funding? Because the IRS does not like underfunded plans. They don’t want employers to underfund plans and jeopardize future retirement obligations for the plan participants.
In some cases, if the plan assets were not sufficient to pay out to the participants, the federal government would need to step in and make the payments. Of course, the federal government does not want to do this, which is why they allow companies to fund a higher amount. This gives the plan an asset “cushion” to prevent any shortfalls to retirees.
How is the Maximum Contribution Calculated?
How is the maximum contribution determined? The IRS permits you to contribute up to 150% of the benefits you have already accrued, in addition to the full amount of any benefit in the current year. Essentially, they allow you to contribute an extra 50% “cushion” amount based on this accrued benefit. Said differently, you may fund for the current year plus an extra 50% over the required participant balance as of the end of the plan year.
This allows you to contribute more but does not raise the defined benefit itself. Consequently, future contributions will decrease unless the defined benefit is increased.
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What is an accrued benefit? It refers to the amount an employee has earned and is entitled to receive as of the end of the plan year, typically December 31st.
But remember, don’t look at that maximum contribution as a “free” contribution. There are strings attached. If you fund the maximum, you will see contributions decrease in the future.
Pro Tip: The IRS permits you to contribute up to 150% of the benefit you have already accrued, in addition to the full amount of any benefit earned in the current year. Essentially, they allow you to contribute an extra 50% “cushion” amount based on this accrued benefit. Said differently, you may fund for the current year plus an extra 50% over the required participant balance as of the end of the prior plan year.
But remember, we don’t recommend that clients fund at that maximum contribution. If you do, future contributions will decrease.
Maximum Contribution Example
Let’s take a look at an example. Assume you issue a W2 of $200k and have a formula that is 100% of compensation. Assuming you are the proper age, your contribution would be $200k in the first year.
For year two, assume again that your W2 was $200k and you earned another $200k benefit. Now, you can fund an extra $100k because you can fund 150% of your accrued benefit (or 50% “cushion” above the actual accrued benefit). So, the target and maximum funding for year two would be as follows:
| Target Funding | $200,000 |
| Maximum Funding | $300,000 |
Final Thoughts
Many clients don’t understand maximum funding amount. It is vital to understand how these amounts work. In addition, your contribution decisions in one year will substantially impact your future funding levels.
Is a Cash Balance or Defined Benefit Plan Right For You?
We always tell clients: each dollar you fund today is one less dollar you can fund in the future. This is way we strongly encourage clients to fund at the target or recommended contribution level.
