Last month, two men who own a small business sought advice on terminating their company’s defined pension plan from Seymour Goldberg, a lawyer at Goldberg & Ingber in Garden City, N.Y.
Goldberg told them some unsettling news: The plan was overfinanced by about $200,000, and the businessmen stood to lose nearly all that excess to taxes if they terminated the plan.
Thanks in large part to the strong performance of the stock and bond markets in the 1980s, a number of small businesses find that their plans are overfunded, or contain more money than is needed to pay the pension benefits of the plans’ participants.
The excess amount is subject to a 50 percent federal penalty if it is withdrawn. In addition, federal, state and local income taxes are owed on the withdrawal. The combination could result in a loss of 99 or 100 cents on the dollar for any excess.
“There are several hundred thousand people in this country in this position,” Goldberg said.
Often, business owners are not aware of the problem until they decide to retire or terminate plans.
“I’ve seen situations where the individual is caught totally off-guard,” said Richard R. Joss, resource actuary in the Seattle office of the Wyatt Co., benefits consultants. “To the person involved, it is a very big problem.”
Working with projections of investment returns and benefits that must be paid, actuaries advise employers on how much money to put in their plans. If the investments perform better than the actuaries project, a plan can end up with more money than is needed to finance its obligations.
For a big company, overfunding can be good news. It means the company need not make contributions-or can make small ones-for a period of time.
In fact, companies bought other companies in the 1980s just to get the excess money in the pension funds. Until 1986, the acquiring company could buy annuities for the plan’s participants, take the rest of the money out, pay corporate income tax and use it.
Lawmakers considered this practice abusive, and placed a 10 percent penalty on the excess money withdrawn from plans as part of the Tax Reform Act of 1986. In 1988, the penalty was raised to 15 percent, and the tax law of 1990 raised it to 50 percent.
The penalty is not a credit against taxes. So, if a pension is overfunded by $100,000, the penalty is $50,000, and the company owes taxes on $100,000.
The problem afflicts small companies because they have few employees and often do not continue after the owner retires.
“Overfunding doesn’t hurt big companies because new employees are always coming in,” said Bill Mischell, an actuary and principal at Foster Higgins, benefits consultants in Princeton, N.J. “But that doesn’t work for a four- or five-person corporation.”
Consultants cite several reasons for overfunding. Some say business owners view the plans as tax shelters and stuff money into them, ignoring the consequences.
Others fault the actuaries. Goldberg said, but some actuaries counter that it is their place to make projections, not give financial advice. And in some cases, an actuary may be pressed to come up with a high maximum contribution as a tax shelter.
Rick Davids, an actuary at Hewitt Associates in Lincolnshire, Ill., said a doctor in private practice might apply more pressure than, say, a corporate officer, because the dollars come out of his own pocket.
“Still,” Davids said, “if I were that small business owner, I would hope that the actuary would apprise me of the downside of putting too much money in to get a tax shelter today.”
Some small-company pension plans become overfunded because the business owners choose to make risky investments that perform very well and outstrip actuaries’ projected returns.
“Lesson No. 1 is don’t put too much in because you can’t necessarily get it back,” Mischell said. “Lesson No. 2 is to be prudent in your investments, because if you invest aggressively and the investments perform spectacularly well, you can’t get your hands on the money. If the investments perform badly you lose, too.”
Although there are no perfect solutions, there are some ways to avoid handing over all of this excess money to the taxman.
“Small-business owners need to become more educated about this problem,” said Davids.
The first step is to examine your plan and determine whether you have a problem. “The trigger should be when the actuary says: `You don’t have to put any money in your plan this year,’ ” said Goldberg. “Then, you should ask why.”
Goldberg tells clients in this situation to terminate the pension plan and roll over the accrued benefit into an individual retirement account. “As soon as you smell an overfunding, you should roll it over so the growth will come in the IRA,” Goldberg said. “It’s better to roll it over when you are overfunded by $50,000 than when you are overfunded by $400,000.”
You still will have to pay the penalty and the tax on the excess amount in the plan, but the idea is to catch the problem early before it compounds.
The plan can also be amended to enrich employee benefits to reduce the amount of excess contributions.
“If the plan didn’t provide joint and survivor benefits for spouses, that could be added,” said Joss. “Or you could amend it to provide cost of living increases or anything else that would increase the benefits.”
Another option for small-business owners who are ready to retire is to share the excess with employees. “You have to decide if you want to give it to participants or if you want to give it to the government,” Davids said.
The penalty on the excess can be reduced from 50 percent to 20 percent in two ways, he said. The first is to share 20 percent of the excess with employees. The second is to transfer at least 25 percent to a qualified replacement plan.
Say your company plan has excess contributions of $100,000. If you take the money for yourself, you pay a $50,000 penalty and perhaps $48,000 in federal, state and local taxes. But if you give 20 percent to your employees, you have $80,000 left. Your penalty is 20 percent of $80,000, or $16,000.
You pay additional taxes of about $38,400 on the $80,000 and keep about $25,600. If you elect this approach, the money is allotted to employees based on their earned benefits, Davids said.
If you decide instead to share all the excess with employees, you pay no corporate tax or penalty and you have much more flexibility in distribution. “You could do it proportional to pay, or to pay and service, or a number of different ways,” Davids said.
Another option is to sell the business. “One creative solution might be to find an underfinanced plan and merge your business with the other business,” Joss said.
There must be sound business reasons to merge, though. “If the sole motivation for the business deal is to recover your excess assets, it’s probably not OK with the IRS,” Joss warned.
