overfunded pension plan,overfunding
Pension overfunding

nest eggAs the name suggests, a defined benefit pension plan promises to pay a fixed annual amount starting at retirement. These retirement benefits are predetermined based on factors such as salary, age, and years of service, and are subject to a maximum annual benefit limit. Each year the employer makes tax-deductible contributions to the plan in order to have enough money available in the future to meet the promised retirement obligations. The plan’s actuary calculates the contribution amounts based on estimated investment growth. If the plan’s investment returns are better than expected, the plan becomes overfunded (i.e. it has more money than is needed to meet all its expected future retirement obligations), and no further contributions are required. Many defined benefit plans have become overfunded in the hundreds of thousands or even millions of dollars. Unfortunately, overfunding has almost no value while it sits in the pension plan; it does not increase the value of participant benefits and it cannot be utilized by a business or its owners.

The pesion excise tax

safe moneyWhen a defined benefit plan is liquidated, the plan sponsor is entitled to the overfunding after satisfying the accrued benefits due the remaining participants. For most closely held businesses and professional corporations, a plan liquidation typically occurs when the owner retires, dies, or sells his business. Because pension contributions are tax-deductible, the sponsor must pay federal and state income tax of about 40% on the overfunding received from a terminated plan. In addition, the overfunding is subject to a 50% non-deductible excise (penalty) tax. The combination of income tax and excise tax eats up 90% or more of the overfunding returned to an employer. Congress imposed the pension excise tax in 1986 to protect retirement benefits of employees at large companies from corporate raiders that could liquidate the pension plans and pocket the overfunding. Unfortunately, the excise tax applies uniformly to all qualified defined benefit plans, it does not distinguish between a large company with thousands of employees and a closely held business with just a few employees. Without an exit strategy, a business owner faces the prospect that the overfunding will only be worth 10 cents on the dollar.

Solutions for overfunding

key to succsessIf the overfunding is small enough, then your pension advisor may be able to help you absorb this excess by maximizing the retirement benefits, adding family members as participants, or possibly using it to buy life insurance. If your plan is significantly overfunded, then you may want to consider the strategic sale option. An owner can sell his company for a price that includes value for the economic benefit of the pension overfunding. We have clients that will pay high value for overfunding because they have a pension deficit. The buyer can efficiently use the overfunding to pay pension liabilities by merging the overfunded plan with its underfunded plan. The IRS has ruled that the use of overfunding to fund underfunded liabilities through a plan merger does not trigger income tax or the reversion excise tax. Because the seller is getting value for overfunding as part of a stock sale transaction, the proceeds are taxed at the favorable 20% federal long-term capital gains rate. The current plan participants will have the option of taking their accrued benefit as a lump-sum distribution that can be rolled over tax-free to an IRA, or as an annuity to be paid from a top-rated insurance company. For owners that wish to continue an active business, a simple restructuring or reorganization can typically be accomplished to get value for the overfunding without disrupting the primary business activities.


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