Surplus Contribution: Tax Rules and Management Options

A surplus in a defined benefit pension plan occurs when the plan’s assets grow to exceed its accrued liabilities, which are the estimated future payments owed to retirees. This overfunding presents both opportunities and regulatory challenges for the sponsoring employer. A surplus can be created by strong market performance, actuarial calculations, and the level of employer funding.

How Pension Surpluses Are Created

A primary driver for pension surpluses is strong investment performance. Pension trust assets are invested in a portfolio of stocks, bonds, and other securities. When these investments perform well, the plan’s assets can grow faster than its liabilities. Higher interest rates can amplify this effect, as they tend to decrease the present value of a plan’s future obligations.

Actuarial gains also contribute to pension surpluses. Actuaries estimate a plan’s liabilities using assumptions about employee mortality, turnover, and salary increases. If more employees leave before their benefits vest or if salary growth is lower than projected, the actual cost of benefits is less than estimated. These deviations result in actuarial gains that reduce the plan’s liabilities.

The level of employer contributions can also lead to a surplus. An employer’s regular payments to the pension plan, combined with investment and actuarial gains, can push the plan’s assets beyond its liabilities. When contributions cause a plan to become overfunded, it can create a surplus, though this may trigger specific tax consequences.

Tax Treatment and Deduction Limits

Tax regulations govern the treatment of pension plan contributions. An employer can deduct contributions up to the plan’s full funding limitation, which is the maximum amount of assets a plan can hold before being considered overfunded for tax purposes. Contributions exceeding this limit are not deductible in the current tax year.

Contributions that surpass the deductible amount are considered nondeductible. These excess amounts can be carried forward and deducted in subsequent years, subject to the same funding limitations. This carryover provision allows employers to eventually receive a tax benefit for their contributions, though it delays the deduction.

Making nondeductible contributions can trigger a 10% excise tax. This tax is applied to the amount of the nondeductible contribution at the end of the employer’s taxable year and is intended to discourage overfunding. The tax must be reported on Form 5330, Return of Excise Taxes Related to Employee Benefit Plans.

Managing a Pension Surplus

An employer has several options for managing a pension surplus. A common approach is to take a “contribution holiday,” which means temporarily suspending or reducing contributions. The existing surplus is then used to cover the cost of benefits for current employees, providing cash-flow relief for the company while requiring careful monitoring to ensure the plan remains funded.

Another option is using the surplus to increase benefits for plan participants. This can be done by improving the benefit formula or providing a one-time cost-of-living adjustment (COLA) to current retirees. Enhancing benefits can be a tool for employee retention and morale, turning the financial surplus into a direct investment in the workforce.

A specialized strategy involves transferring surplus assets to fund retiree health benefits. An employer can move a portion of the pension surplus into a separate account to pay for qualified retiree medical expenses. The SECURE 2.0 Act of 2022 updated the rules for these transfers, making it an efficient way to address retiree health obligations with tax-sheltered pension assets.

An employer may also consider terminating the pension plan to recapture surplus assets, a process known as an employer reversion. This involves funding all benefit obligations to participants and then taking back the remaining assets. While this allows the employer to access the surplus cash, it comes with tax consequences.

Tax Consequences of Employer Reversion

When an employer terminates a pension plan and receives a reversion of surplus assets, the amount is taxed in two ways. First, the reverted amount is included in the employer’s gross income and is subject to the company’s regular corporate income tax rate. This ensures the funds, which grew in a tax-deferred trust, are taxed upon their return.

In addition to income tax, the law imposes a 20% excise tax on the reversion amount. However, this rate increases to 50% unless the employer either establishes a Qualified Replacement Plan (QRP) or provides specific benefit increases to plan participants. The combination of this excise tax and regular income tax can make a direct reversion a costly option.

To keep the excise tax at 20% by using a QRP, the employer must transfer at least 25% of the maximum possible reversion amount to the new plan. The QRP must also cover at least 95% of the active participants from the terminated plan who remain with the employer.

The second method for maintaining the 20% tax rate is to provide pro-rata benefit increases to the participants of the terminating plan. This is done by amending the plan to increase accrued benefits. The total present value of these increases must be at least 20% of the maximum reversion amount.