Blog - WEALTH ADVOCATE GROUP (2024)

The Benefits of an Overfunded Pension Plan and When to Correct It

You’ve probably heard of underfunded pension plans in the news many times. Countless companies do not have enough cash on hand to fulfill their current and future retirement income obligations. While this is the most common scenario, there are also overfunded pension plans where the assets in the plan are greater than the liabilities, or future payouts, owed to the plan participants.

There are several benefits to an overfunded defined benefit plan, but they come with their own set of challenges business owners must overcome. This leaves business owners with the choice of whether or not to correct it. In this article, we will discuss the benefits of an overfunded pension plan and when and how to correct it, if complications arise.

Benefits of an Overfunded Plan

An overfunded pension plan’s chief benefit is that the assets are greater than the plan’s liabilities. The plan is in a position to pay the full value of participants’ pensions throughout retirement. An overfunded plan provides confidence to both the employer and employees. Employees know they will be supported by the company throughout the entirety of their retirement. From the organization’s standpoint, having an overfunded status is much more desirable than being underfunded. An underfunded plan subjects the employer to increasingly higher minimum contributions to make up for the shortfall and potential benefit distribution restrictions. An underfunded plan also exposes the company to possible legal action from plan participants.

Complications of an Overfunded Plan

If being overfunded is a good thing, then what’s the problem? Issues start to arise when a defined benefit plan gets to the point where it is overfunded by hundreds of thousands or even millions of dollars. Upon liquidation, the overfunded amount is subject to income taxes and an excise tax of 50%, equating to up to 90% in taxes paid back to the government! The money also cannot be withdrawn unless the plan is terminated. As a result, small business owners are often hit the hardest by these challenges. (1)

To illustrate an example, let’s say you are a sole proprietor and the only employee/participant in your defined benefit plan. You’ve made contributions to the plan over the years, and the underlying investments have fared better than expected to the point where the plan is overfunded by $2 million. As a small business owner, you don’t want to lose 90% of that money to the government when you ultimately retire or exit the business.

When & How to Correct an Overfunded Plan

The time to correct an overfunded plan is when the owner is looking to retire or otherwise do away with the business. There are several actions a business owner can take to mitigate the taxes applied on an overfunded pension balance:

• Cease contributions to the plan until it is corrected. The company can stop funding the plan hoping that the funding level will get back in line.
• Enhance existing benefits.By amending the plan, the business may eliminate the overfunded balance by increasing the existing benefits for plan participants.
• Leverage 401(k) matching.If the company has a 401(k) plan, they can apply the overfunded portion to an employer match.
• Add family members as participants.The organization can hire family members as employees and add them as plan participants, giving them access to the pension benefits.
• Use the overfunded balance to purchase life insurance (if the plan allows).Depending on the situation, the owner may be able to purchase life insurance with an overfunded balance. (2)
• Sell the business.The company could be bought by another company with an underfunded pension plan. The overfunded plan supplements the shortage in the underfunded plan by combining the two. (3)

Need Help With an Overfunded Plan?

Trying to figure out how to correct an overfunded pension plan? Determining the best course of action can be time-consuming and confusing. We can help. At Wealth Advocate Group, we are dedicated to helping business owners and their families accomplish their financial goals. To get started, call 440-505-5751 or email jcohen@Wadvocate.com to schedule an appointment.

About Jason

Jason Cohen is Chief Operating Officer and wealth advisor at Wealth Advocate Group, LLC, an independent, fee-based wealth management company. Jason has 15 years of experience and spends his days managing firm operations, including portfolio trading and analysis, training of new advisors, financial plan production, and client relationship management. Jason specializes in serving real estate professionals and other independent contractor business owners, helping them navigate their unique financial challenges, such as unpredictable cash flow and tax issues, so they can pursue financial independence and freedom from worry. Jason has a bachelor’s degree in public management from Indiana University and is a CERTIFIED FINANCIAL PLANNER® professional and believes that everyone should have access to comprehensive financial planning. He is passionate about doing his best for his clients and setting others up for success. Outside of the office, you can find Jason staying active in a variety of sports and spending time with friends and family. Learn more about Jason by connecting with him on LinkedIn.

This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does the advisor assure that, by using the information provided, the plan sponsor will be in compliance with ERISA regulations.

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(1)https://activewealth.com/defined-benefit-plan-business-owners/

(2)https://www.emparion.com/overfunded-underfunded-cash-balance-plan/

(3)https://www.emparion.com/overfunded-underfunded-cash-balance-plan/