Requirements
and Limits
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Requirements
and Limits
The Internal Revenue Code (IRC) specifies procedures for calculating both a minimum required and a maximum deductible contribution for a defined benefit plan. Both contributions are based on the monthly pension accrued to date, the additional monthly pension expected to be earned during the year, and a prescribed set of interest and mortality assumptions that are updated each year as interest rates change and mortality improves (i.e., people live longer). There is generally a wide range between the minimum and maximum.
In addition to calculating the minimum and maximum, we typically also calculate a recommended contribution which is a “level amortization” of the amount necessary to pay benefits already earned and expected to be earned as they become due. Often, this recommended contribution falls between the statutory minimum and maximum.
The calculations of contribution amounts are based on the ages, compensation, and length of service of the participants in the plan, the value of the assets already in the plan and assumptions about future events. At retirement (or termination of employment), the participant is entitled to a monthly benefit. For purposes of payment, the monthly benefit may be “converted” into a lump sum payment. The lump sum payment is based on the monthly accrued benefit and the age of the participant at the time of the distribution -- not how much money is in the plan.
Contribution Requirements
The employer is required to make contributions to fund a defined benefit plan.
The plan may be amended in order to reduce the required contribution. Failure to contribute the required amount may result in an excise tax. Contributions for a plan year can be deposited up to 8½ months after the end of the plan year.
Contribution/Deduction Limits
The employer deduction limit for a DB plan is a function of the contribution calculation, not a percentage of compensation. There is usually a wide range between the minimum required amount and the maximum deductible amount. The employer can deposit an amount anywhere within that range.
Where the DB plan is not covered by the PBGC, the annual employer deduction limit for an employer with a combination of DB and DC plans is 25% of eligible compensation or the minimum required contribution to the defined benefit plan, if greater. However, even if the minimum required contribution for the DB plan is over 25% of eligible compensation, an employer may still make a deductible contribution up to 6% of eligible compensation into a DC plan. Salary deferrals do not count toward this limit.
The 25% of pay limit does not apply if the DB plan is covered by the PBGC.
Individual
Contribution and Benefit Limits
Since the contribution to a defined benefit plan is not allocated to individuals, there is no individual contribution limit for a DB plan. Instead, there are annual benefit limits.
In a DB plan, the benefit for each participant is limited to the average of the highest three consecutive years of his or her eligible compensation. This may include years before the plan was established. This limit is further reduced if the participant has less than 10 years of service with the plan sponsor. For very highly compensated employees, the benefit is also limited by a monthly dollar limit, which is reduced for a retirement age less than 62 and for less than 10 years of participation in the plan. This limit generally affects only owners and very highly compensated employees.
This limit applies to the monthly pension benefit at retirement. The maximum lump sum payable by the plan is the present value of this limit.