You probably know by now that your plan funding comes with a target contribution and a minimum and maximum. But what do these numbers mean and why are they important?
The critical point to understand is that what you fund in a given year has a big impact on what you will be able to fund in subsequent years. Every dollar you put in today is one less dollar that you can contribute in the future. As a plan administrator, we always urge clients to fund at the target contribution level.
The IRS allows you to overfund your plan by allowing a “maximum” contribution. But this overfunding is not “free” and it comes at a steep cost. It reduces future contributions.
This article will discuss your funding range. More importantly, it will detail why it is so important to fund as close to the “target” contribution as possible. Let’s dive in!
Before we get to the details, let’s briefly discuss the three funding levels. The following summarizes what a target contribution represents along with the minimum and maximum contributions:
Your target contribution is the amount you need to keep your plan funding on “target.” This keeps the plan from being overfunded or underfunded.
Remember that a defined benefit plan will actually “define” a benefit at retirement. This benefit is calculated each plan year by the actuary.
How is the target contribution determined? The actuary uses your age, compensation, and asset returns to develop a straight-line methodology to equal your benefit at retirement. This amount is adjusted every year based on your age, changes in compensation, and your actual asset returns.
Even though we recommend that you fund the target amount, the IRS gives you the ability to fund greater than the target amount. This gives you some funding flexibility. However, if you fund to the maximum you need to understand that this will reduce future contributions.
How is the maximum contribution determined? The IRS allows you to fund 150% of the benefit already accrued plus the full amount of benefit increases in the coming year. This allows you to fund a higher amount but does not increase the defined benefit. As a result, future contributions will decrease unless the defined benefit is increased.
As a result of overfunding in prior years or possibly higher asset returns, you might find that you have a minimum contribution that is below the target level. As a general rule, defined benefit plans come with mandatory contributions.
However, this is not always correct. Because of aggressive funding you might find that the actuary determines that funding is not required to keep your plan on target.
You must at least meet the minimum contribution or else you will have an excise tax penalty. This is generally an amount that is 10% of the contribution shortfall.
Specifics of target contributions
You can think of your target funding as a 45° angle going from zero to a final benefit at retirement. If you fund this amount every year, you will stay right on the 45° line and your plan will not be overfunded or underfunded until you reach the final benefit.
But if you fund above or below the 45° line, your plan will be technically overfunded or underfunded. Minor overfunding or underfunding is not that big of a deal, but it will still impact your future contributions.
Remember that your compensation will determine your final benefit at retirement. The benefit will be achieved based on a combination of contributions and earnings on those contributions. But the final benefit will only change if your compensation changes.
For example, let’s assume your actuarial benefit is $2 million and you have 20 years until the retirement date. If you fund the target with consistent compensation, it will be straight-line contributions to $2 million. But if you fund the maximum amount, future ranges will start to come down. Likewise, if you fund at the minimum then future contributions will increase.
But at the end of the day, either funding level will get you to $2 million. Said differently, if you overfund or underfund the actuary will pull your contributions back in line as you reach the final $2 million benefit.
Specifics of maximum contributions
IRS rules drive the maximum funding allowed. Thankfully, the IRS allows companies to fund additional amounts into plans. Generally speaking, they would prefer to have plans overfunded (or at least comfortably funded) and not underfunded. They’re generous to allow higher contributions than required, while still allowing them to be tax deductible.
The maximum deductible amount is equal to the value of benefit increases for the year plus 150% of the plan liability less plan assets. In addition, the company can fund the value attributed to expected future compensation increases. If benefits were increased for highly compensated employees in the last two years, the liability increase attributed to that amendment may not be fully reflected.
Let’s look at an example. Assume you have a W2 of $100k and use a 100% formula. In year 1, your contribution would be $100k. Assume that your W2 was still $100k in year two, and you earned a 100k benefit. However, you can fund an extra $50k because you can get 150% of your accrued benefit.
The critical issue to understand is that if you overfund a defined benefit plan, future contributions will decrease over time.
The IRS rules allow a plan to be funded to appoint that is 50% over your accrued benefit. What is an accrued benefit? This is the amount that the employee has earned and is entitled to as of the end of the plan year, which is typically December 31st
Specifics of minimum contributions
The minimum funding contribution equals the value of any plan benefit increases in the coming year plus a the 15-year amortization of unfunded benefits that are already accrued. If the plan is overfunded, there is not an unfunded benefit.
In this case, the value of benefit increases is reduced by the amount of any funding surplus. In addition, if the plan has been aggressively funded, there might not be a required contribution. Because many business owners want to overfund their plan, minimum amounts are often not required.
As stated above, we always recommend that clients fund the target contributions. The IRS does allow you to overfund your plan. But this overfunding comes at a steep cost. It reduces future contributions.
At the end of the day, all funding leads to final defined benefit. So, every dollar you put in today is one less dollar that you can put in in the future.