#1 Strategy for an Overfunded Defined Benefit Plan [Step by Step]

Cash balance plans and defined benefit pension plans can be complex. In fact, they can be so complex that overfunding issues occur.

If you find that you have an overfunded pension, don’t be too concerned. In most situations, there are strategies that can eliminate (or at least substantially reduce) the problem.

As you will see, excise tax penalties and income tax can exceed 90% of the overfunded balance! But in reality, I have only seen it happen a few times. Careful planning is critical.

In this guide, I will discuss some of the ways to fix these pension problems. I will also offer some practical solutions and even an example. Let’s dive in.

What is an overfunded cash balance plan or defined benefit plan?

What is an overfunded defined benefit plan? This can be somewhat complex.

In theory, an overfunded defined benefit plan is a simple concept. It is when pension assets exceed pension liabilities.

Pension assets are the fair value of the plan investments. Pension liabilities are the present value of the expected retiree benefits.

Here’s how the process starts. On an annual basis, the plan actuary provides an analysis of the plan and completes the required IRS forms. The goal is to determine a funding level for the current year and make sure that the plan is operating correctly.

What determines whether a pension plan is underfunded or overfunded? The plan’s actuary analyzes the following to determine funding levels:

• Compensation levels and salary history of employees;
• Pension assets and liabilities as of the end of the plan year or fiscal year;
• New hires and current employees;
• Specified interest crediting rate; and
• Employee pay credits.

Once the actuary finalizes the review, a determination is made as to whether the plan is underfunded or overfunded. The actuary will then determine a funding range for the current year contribution.

A little underfunding or overfunding is OK. In fact, the IRS even allows it. But if the overfunding or underfunding gets bad, problems arise.

How does a cash balance plan become overfunded?

The analysis performed by the actuary may sound very objective. But in reality, defined benefit plan funding is a constant juggling act. This results from the following:

• Compensation amounts going up and down;
• Investment returns being very volatile;
• Plan amendments and market changes, including interest rates;
• Actuary funding ranges that can be wide; and
• Application law changes.

However, I have found the single largest reason for an overfunded pension is a high return on plan assets. The business owner simply invested the assets into an aggressive growth stock portfolio, and it got out of control.

I have seen defined benefit plans invested in bitcoin, other cryptocurrencies and volatile stocks like Tesla. Not such a great idea.

Paul Sundin, CPA

As a CPA, Paul has extensive experience with overfunded pension issues. Schedule a FREE call to discuss your overfunding issue and to review your options.

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Actuaries don’t often stay on top of the issue (at least not as much as the owner would like). The result is a large overfunding issue. Here is where the problem begins.

What is reversion and the excise tax?

So, why is an overfunded plan such a big deal? It’s because of something called reversion.

Reversion occurs when a company terminates an overfunded pension plan. The excess assets (overfunded amount) is reverted back to the company. It is then subject to an excise tax of 50%.

In addition, this amount is subject to federal income tax as well as state incomes taxes. To make matters worse, the excise tax is not tax deductible.

With all the penalties and taxes, most people will lose around 90% of the overfunded balance. If you happen to live in a state with a high state income tax (like California), you might actually lose the entire amount and then have to come out of pocket thanks to the state income tax!

The IRS established excise tax back in 1986. It was a way to combat corporate raiders from liquidating pensions.

Companies would buy other companies with large pensions. They would then pay out minimum benefits and keep the rest for themselves. So there were good intentions when the excise tax was established.

The IRS used the law to target large corporations. However, the tax is applicable to all cash balance plans (large and small).

In summary, business owners must do careful planning or they can find themselves paying the 50% excise tax and then an additional 40%. A 90% tax is quite a hit.

Why resolving the problem ASAP might be your best option

As you can see from the previous example, the penalties and tax for terminating an overfunded pension are huge. So you should do ever thing in your power to avoid them.

It’s important to know that as a CPA, I generally would prefer to have my clients avoid tax in the current year and pay the tax at some point in the future. Said differently, you want to push the tax liability into the future.

This is essentially taking advantage of time value of money. But also allows you to strategize to take the income in a year in which you might be able to utilize a different tax structure or be in an overall lower tax bracket. In any event, the goal is usually to avoid paying the tax in the current year.

Why should I pay the tax now?

But sometimes, it makes sense to accelerate the tax and pay it in the current year. This is often because you expect higher income and higher tax brackets in future years. You also might be considering legislation that might increase overall tax rates.

But often, overfunded pensions are another reason to accelerate the tax today. The reason is again because of time value of money.

The problem with overfunded pension plans is that most owners keep the funds either not invested or invested at a very low rate of return. If you earn 7% annually, an account balance will double in 10 years.

So in many situations, it makes sense to roll the accrued portion of the plan into an IRA and then do a strategic sale with the overfunded portion. Once the funds are in an IRA, it will not have the same restrictions, and the investment returns are unlimited.

If you run this scenario out over 10 years you might find that this is your best option. But make sure you run the numbers with your CPA and financial advisor.

Terminating an overfunded defined benefit pension plan

It is important to note, that having an overfunded plan is not itself a problem. It is the actual termination that results in reversion.

So if the plan is kept open indefinitely there is not a problem. But at some point you will need to get the money out of the retirement plan. The reason it was set up in the first place was to provide funds during retirement.

The key is to manage the funding such that in the case of termination there is not a problem. This is why annual coordination with the plan actuary is so critical.

Paul Sundin, CPA

As a CPA, Paul has extensive experience with overfunded pension issues. Schedule a FREE call to discuss your overfunding issue and to review your options.

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The actuary can review the funding levels and any compliance requirements. The plans fall under the Employee Retirement Income Security Act (ERISA), so those issues need to be addressed as well.

Remember that if an overfunded plan is ultimately terminated and liquidated, the company would pay an excise tax on the excess funds because the contributions were tax deductible. The overfunded balance is subject to the 50% excise tax. Unfortunately, this tax is non-deductible.

How to correct an overfunded defined benefit plan

There are many ways that TPAs and financial advisors can help companies correct overfunded plans. Depending on how much the plan is overfunded, there are many options to consider. This is where the company needs to make sure that they work with experienced professionals.

Enhance Existing Pension Benefits

The company may use the surplus funds to maximize the current plan benefits without significantly changing actuarial assumptions or benefit formulas. Participant allocations are based on a specified amount or percentage of salary. This would enable the participants to receive larger benefits at retirement.

Match 401(k) Contributions

A company can (in some situations) use overfunding to match employee contributions to a 401(k) plan. The funds reside in a “sub-account” within the cash balance plan. Contributions can also be rolled over into a qualified replacement plan (QRP).

Include Family Members as Participants

For small, closely held companies this can be a great option. The company can add family members as plan participants.

The company does not have to make additional funding thanks to the overfunding. Family members receive the pension benefit allocation. But make sure you discuss the issue with the TPA and your accountant.

Consider Including Insurance

Businesses can use overfunding to buy life insurance. There are certain limitations and specific rules when using life insurance in a plan. The first step is to amend the plan document to allow for the change.

The reason this helps reduce over funding is because a large portion of the initial insurance payments go the premium and not the assets. The insurance company structures the policy so that you see an immediate drop in the value of plan assets. This can lower excess assets and get the plan funding in line. There are a few ways to structure the annuity contract.

Strategic Sale

Substantially overfunded plans can be challenging to fix. One option can be to sell the company to another company that has an underfunded plan. After the purchase, the purchaser merges the overfunding plan with the underfunded plan.

In some situations, companies that been near bankruptcy with overfunded pension plans have used this strategy with great success. The sale may allow them to get more money for the company. But this is more challenging for small family owned companies.

Some IRS rulings have supported these business acquisitions. The goal of course is that the merger of the plans should not trigger current federal or state income tax and also avoid excise tax. Profits are subject to capital gains tax, which is still less than the excise tax.

An important point to consider is that the Pension Benefit Guaranty Corporation (PBGC) is often happy with this solution because it eliminates some of the risks of unfunded benefits that it might have to fund at some point in the future. The lower risk to the PBGC could benefit the public since it lowers the chance of a potential bailout.

Overfunded pension plan example

So let’s take a look at a specific example. Let’s assume we have a company with one employee (the owner). The defined benefit plan has an investment account balance of $3 million.

However, the owner only has an accrued benefit of $2.3 million. As such, the plan is $700,000 overfunded. Let’s also assume that the owner is 62 years old and is in a 40% tax bracket (federal and state).

If the owner terminated the plan immediately, the following taxes and penalties would occur:

As you can see from the example, the owner only ends up with 10 cents on the dollar! Remember that the excise tax penalty and the income tax are both based on the gross overfunded amount. That’s because the excise tax itself is not tax deductible. Many people miss this distinction.

Very few owners would be looking to pay that type of tax upon termination. So let’s see what options the owner has.

Leave the plan open?

Assuming the owner still is working in the business, he could consider leaving the plan open. Because the account balance of $3 million is less than the maximum amount of $3.1 million, he may find that he will not be overfunded if he terminates the plan in the future.

However, he would want to ensure that his future compensation will be enough to mitigate the overfunded balance. In addition, he should make sure his investments are conservative. If he gets high investment returns, it will widen the gap between his account balance and his accrued benefit at some date in the future.

Also, it is essential to note that the $3.1 million maximum amount in a defined benefit plan is indexed annually by the IRS. So for example, if he goes to terminate the plan ten years down the road, the amount might be $3.5 million. This allows for more flexibility.

Paul Sundin, CPA

As a CPA, Paul has extensive experience with overfunded pension issues. Schedule a FREE call to discuss your overfunding issue and to review your options.

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Does the owner have family members who can work in the business? Can the plan be amended to increase the accrued benefit?

So what if the owner is no longer working in the business? He still could consider keeping the plan open. Tax laws could change, and he may be able to work through the company at some point in the future.

But in most situations, you’re just kicking the problem down the road. In addition, you must keep your plan assets very conservative, and you’re going to miss out on a high rate of return (as discussed above). It often makes sense to get out of the plan as soon as possible to get the funds into an IRA without the funding restrictions.

What are the other options?

If the owner and family are not working in the business or the business itself is defunct, there are only a few options remaining. It typically comes down to moving the funds into a QRP, acquiring insurance or a strategic sale.

How to resolve an overfunded pension

Final thoughts

You probably know why defined benefit plans are one of the best retirement strategies in the market. They offer tax-deductible contributions with specific benefit payouts and large annual contributions in early years. But they do come with investment risks for plan fiduciaries.

As you can see, they can have overfunding problems. The issue is prevalent for traditional defined benefit plans and also cash balance plans. It takes careful coordination with the actuary, CPA and financial advisor.

Hopefully, the information provided (and our example) allow you to make an education decision on your overfunded plan. A little education can go a long way!

Paul Sundin, CPA

As a CPA, Paul has extensive experience with overfunded pension issues. Schedule a FREE call to discuss your overfunding issue and to review your options.

Schedule Appointment