Front-loaded Funding – Defined Benefit Plan

[Pete]

I have a client who began a business this year. It is an S corporation and he is the only employee. He does not plan to have other employees.

This year his salary will be $2 million. His profit after his salary will be $5 million.

He is age 55 and he plans to work for this business for 10 more years.

He does not have a retirement plan for this business or from any other employment or business. He would like to set up a defined benefit plan this year. 

He would like to know what the maximum amount is that he can fund and deduct this year. 

He feels certain that he will participate in the plan for 10 years and that his salary from this business will exceed $300,000 for 3 consecutive years.

Could anyone tell me what provision in the Code or regulations would limit him from funding his entire life-time benefit in the first year?

I am aware that under Code section 404(o), the deduction is limited to his “target normal cost”.

To my reading, Code section 430(b) and Regulation section 1.430(b)(1) define target normal cost based on the benefits provided in the plan.

Is my reading correct? If a plan provides that the entire life-time benefit is earned in the first year of participation, can the present value of that amount be deducted in the first year?

[C. B. Zeller]

415(b)(5) provides that the maximum annual benefit is prorated for less than 10 years of participation. In the first year the maximum benefit he can accrue is 1/10th of the annual dollar limit.

[david rigby]

Rather than advise you to re-read 404(o), I suggest you talk to a pension actuary who specializes in these small plans.  That actuary may also advise you that the point of this plan (BTW, your client is the perfect candidate) is not to maximize investment return, but to maximize the deduction.  Use a DC plan for aggressive investment strategy.

[Pete]

Z.B. Zellner, Thanks! This is helpful. May I ask a follow-up question?

In Years 2 through 5, may my client fund a “cushion amount for the plan year” under section 404(o)(2) of 50% of the previous year’s target normal cost (i.e. 50% of the previous year’s 415(b)(5) amortization of maximum annual benefit)?

Would this be a way, during the early years, of front-loading the funding? I realize this would be adjusted for actuarial changes. 

Under this strategy, would funding in later years be reduced to adjust for the fact that the plan was overfunded by the accumulation of the cushion amounts in the earlier years?

[Pete]

David Rigby, Thank you for the insights!

[Mike Preston]

3 hours ago, Pete said:

Z.B. Zellner, Thanks! This is helpful. May I ask a follow-up question?

In Years 2 through 5, may my client fund a “cushion amount for the plan year” under section 404(o)(2) of 50% of the previous year’s target normal cost (i.e. 50% of the previous year’s 415(b)(5) amortization of maximum annual benefit)?

Would this be a way, during the early years, of front-loading the funding? I realize this would be adjusted for actuarial changes. 

Under this strategy, would funding in later years be reduced to adjust for the fact that the plan was overfunded by the accumulation of the cushion amounts in the earlier years?

Yes, and it should be.