Overfunded defined benefit plans can create a tax problem upon termination. However, very few clients are even aware of this potential issue.
Specific concerns are known as “reversion” and “excise tax.” If your plan is subject to these, you will lose around 90% of the overfunded amount!
This article explains tax issues with overfunded plans and how the excise tax and reversion rules work in plain language. It will also outline practical ways to reduce or eliminate moderate overfunding. Let’s jump in!
Background
When solo business owners have a defined benefit plan, they typically treat the entire investment account balance as their own. But this is technically not correct.
Defined benefit plans work very differently from defined contribution plans, like 401(k)s. Defined contribution plans will generally have participant balances. So, these accounts are rightfully owned by the participants.
But a defined benefit plan targets a benefit at retirement for each individual participant. The investment account assets are “pooled” and actually controlled by the plan trustee. The participant only has a right to a future benefit or the present value of that benefit if or when they leave the company.
For example, let’s assume a 50-year-old solo business owner is entitled to a $2 million benefit at age 62. The business (also called the plan sponsor) is required to make contributions towards this future benefit.
The actuary reviews the plan assets annually and requires the plan to contribute towards that future benefit as needed. If, at age 62, the plan has $2.2 million, this would result in an overfunding of $200,000.
Many business owners don’t consider “excess” assets and assume they will receive the entire account balance (in this case $2.2 million). In reality, surplus assets can trigger excise taxes and ordinary income taxes.
How does a plan become overfunded?
In general, overfunding occurs in two specific situations, both of which are under the control of the business owner. They happen when:
- The company has investment returns that exceed the interest crediting rate (typically 4-5%).
- The company funds in excess of the “targeted” or “recommended” amount provided by the actuary.
The key point is simple. If the plan terminates while overfunded, surplus assets create a taxable event. You are no longer dealing only with “retirement plan rules.” You are dealing with excise taxes and ordinary income taxes together.
What “Overfunded” Really Means When You Terminate a DB Plan
So, what happens to the excess or surplus assets upon termination?
They are subject to two types of penalties and taxes:
- The first layer is a 50% excise tax.
- The second layer is what is called “reversion.” This is returned or “reverted” back to the business as taxable income.
When you combine these taxes and penalties, the impact can be enormous. In most situations, the business will forfeit close to the entire overfunded balance. We’ll show you an example shortly.
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But before you panic, you should realize that we almost never see reversion in practice. Why? Because there are many options to solve this issue. We will discuss them below.
The 50% Excise Tax and How It Gets Reported on Form 5330
When surplus assets revert to the employer, an excise tax applies under Internal Revenue Code Section 4980. The Code sets a 50% rate as a general rule.
This excise tax is reported on Form 5330 and remitted directly to the IRS. The filing timing is tied to the period in which the reversion occurs. That timing matters because the excise tax is not handled on the normal income tax return.
The point is not to memorize the form lines. The point is to understand the structure of the penalty. If you take surplus assets back, you trigger a separate tax return and payment.
Reversion Also Creates Taxable Income Back to the Business
As discussed, the excise tax is only the first hit. A reversion means the employer receives money back from the plan. That receipt is generally treated as income to the business.
If the business was an S-Corp or C-Corp, the reversions would be considered revenue and Forms 1120-S and 1120, respectively. If the business was a sole proprietor, then the reversion is reported on Schedule C to the 1040 tax return.
State income tax can also apply depending on the business location. So, you may face federal income tax plus state tax on the reversion.
Is a Cash Balance or Defined Benefit Plan Right For You?
This is why overfunding can feel like a trap. You previously received a tax deduction for plan contributions. Now, the surplus comes back and becomes taxable. The system effectively recaptures part of the earlier deduction through taxes.
Let’s Look at an Example
Assume a solo business owner is terminating a plan with $1,000,000 in assets. The accrued benefit to the sole participant is $900,000. This results in an overfunded amount of $100,000 that would be subject to excise tax and reversion. Let’s also assume that the owner has a combined state and federal tax rate of 40%.
A 50% excise tax will consume $50,000 immediately. In addition, the entire $100,000 is reverted to the business and treated as taxable income. Based on the combined marginal tax rate, the tax would be $40,000. As a result, the business owner nets only $10,000 from the original $100,000 surplus.
Take a look at the example in the table below:
| Item | Example Amount | Notes |
|---|---|---|
| Overfunded surplus at termination | $100,000 | Assets exceed required liabilities |
| Excise tax at 50% | $50,000 | Reported on Form 5330 |
| Amount reverting to employer | $100,000 | Taxable amount returned to the business |
| Income tax at 40% | $40,000 | Calculated on the gross overfunded amount |
| Net retained by employer | $10,000 | Net of all penalties and taxes |
As you can see, the owner does not get a tax deduction for the excise tax penalties. That is why people talk about “losing around 90%”.
The big lesson is not the exact percentage. The lesson is that reversions are heavily discouraged through taxes.
Why the 50% Excise Tax Payment Is Not Deductible
Many business owners assume the excise tax penalty will reduce the taxable income to the business from the reversion. Unfortunately, this is not the case.
The excise tax on an employer reversion is a federal excise tax. Those excise taxes are not deductible under the federal nondeducibility rules.
Internal Revenue Code Section 275 disallows deductions for certain federal taxes. That includes specified excise taxes imposed under particular Code chapters, such as Section 4980. So, the excise tax payment typically does not generate a tax deduction.
That matters because it makes the excise tax more expensive. If the payment were deductible, it would partially offset itself. The economic hit is larger than many clients assume.
Process for dealing with Overfunded Assets Upon Termination
Here is the step-by-step process to dealing with overfunded plans:
- Have an actuary determine whether the plan is overfunded and identify the exact amount.
- Review the overfunded amount with the business owner and discuss how to mitigate or reduce the amount.
- Assuming that the business owners agree to the reversion, move the non-excess assets over to an IRA, 401(k) or another qualified plan.
- Move the surplus or excess assets back to the business entity that sponsors the plan.
- The administrator should prepare Form 5330 and remit to the business owner so they can file the form and pay the amount using the remittance.
- File a 1099-R for the amount that was rolled over to the 401(k) or IRA and ensure it does NOT include the overfunded portion.
Ways to Mitigate or Eliminate the Excise Tax and Income Tax
Here are the top ways to mitigate:
- Keep the plan open. In many situations, the company can just keep the plan open for an additional year or two, so the participants earn more accrued benefit. A short extension is often the simplest operational fix. Another year of participation can increase accrued benefits, raise the plan’s termination liability, and naturally consume the overfunded balance. This approach can be especially effective when the surplus is modest.
- Use a qualified replacement plan or “QRP.” A QRP can be established to reduce the excise tax rate and move surplus out of “reversion” territory. If you maintain or adopt a qualified replacement plan (typically a defined contribution plan) and satisfy the technical requirements, you can transfer all or a portion of surplus into the replacement plan, which reduces the surplus amount. As such, it reduces both the excise tax base and the income that would otherwise come back to the business.
- Other options. There are other available options that are discussed here.
Bottom Line
The takeaway is straightforward. If you terminate a defined benefit plan with surplus and take a reversion, taxes can be extreme. You can face a large excise tax plus ordinary income tax on the reverted amount. Planning ahead, including a potential extra plan year, can often prevent the worst outcome.
When you combine the excise tax and income tax, the net can be shocking. A 50% excise tax leaves only 50 cents on the dollar. Then income tax applies to what comes back as taxable income. The remaining value can shrink dramatically after both layers.
There are several strategies to mitigate or eliminate moderate overfunding. Some strategies reduce the excise tax rate. Other strategies reduce the surplus before the plan ends. The best approach depends on plan terms, participant demographics, and timing.
