February 21, 2019
A Defined Benefit Plan (“DB Plan”) is a type of retirement plan that allows for significant tax-deductible contributions. In fact, for a high-income business owner, allowable contributions can be as high as $100k to $250k+ per year.
However, Defined Benefit Plan contributions are not discretionary. Generally, contributions are required each year. The permissible contribution range for a given year is calculated by the Plan’s actuary. Based on this range, the employer decides how much they would like to contribute. At a minimum, the employer must contribute the required contribution amount. To the extent that more is contributed, the excess amount can be “stored” and applied against future contribution requirements. This “credit” is called a Credit Balance and is the subject of today’s post.
A Credit Balance is the accumulation of “extra” contributions deposited. It is a “paper balance” – it is not a separate account with assets. Once established, a Credit Balance may be used to reduce future required contributions if certain conditions are met. For example, if the required contribution was $100 and the Credit Balance was $75, the employer could apply the full Credit Balance so that only $25 was required for the year. The employer also could decide not to use the Credit Balance at all or to only use a portion of the balance, saving it for future years.
There are two types of Credit Balances. The first type is for balances established prior to the effective date of the Pension Protection Act of 2006 (“PPA”). The second type is for balances established after PPA. These types of balances are tracked separately. For the most part, the two types of balances are the same. However, pre-PPA balances have some additional advantages, which won’t be described here. For purposes of this post, we will assume all Credit Balances are post-PPA balances.
In a year that the employer contributes more than the required amount, the excess can create a Credit Balance. For example, if the required contribution as of January 1 is $400 and the employer contributes $600 on that date, an excess of $200 would result. If the employer makes a written election to create the Credit Balance, the $200 excess would be increased with interest to the end of the year and create a Credit Balance. This amount could then be applied against future contributions under certain conditions.
In subsequent years, the existing Credit Balance would increase (or decrease) annually using the Defined Benefit Plan’s asset rate of return. Additional excess contributions would be added to the existing balance as described above. The Credit Balance also would be reduced for amounts applied against the contribution requirement and for amounts “waived” (more on this later).
An employer can use a Credit Balance if at least 80% of the prior year Plan obligations were funded. For example, if for the prior year, Plan liabilities were $100, then Plan assets must have been at least $80 for the employer to apply the Credit Balance against the contribution requirement. What’s more, Plan assets must be reduced by existing Credit Balances when determining if the Plan is 80% funded. Thus, having a large Credit Balance could mean that you cannot use it!
In this case, the employer can make a written election to “waive” a portion of the Credit Balance so that the Plan is at least 80% funded, and the remaining Credit Balance could be used in the subsequent year. Note that in some cases, the Credit Balance may be automatically waived if the Plan falls below certain funding thresholds and a waiver of Credit Balance would increase the funded status above that threshold.
A Credit Balance can be very helpful if, in a given year, the employer has difficulty satisfying the contribution requirement. However, for small business Defined Benefit Plans, setting up a Credit Balance may not make sense.
For example, generally, business owners intend to contribute the maximum deductible rather than the minimum required amount, so that a Credit Balance may never be needed. In addition, by depositing large contributions, business owner Plans are often well-funded with manageable contribution requirements. Additionally, Credit Balances can create unintended consequences. For example, Credit Balances may have to be subtracted from Plan assets for certain funding ratios, which may create negative consequences for the Plan. Although these consequences can be managed with careful monitoring and, when needed, written employer elections to waive all or a portion of the Credit Balance, the additional time and paperwork can be onerous.
That being said, in some instances, a business owner may be willing to spend additional time on the Defined Benefit Plan to have the extra layer of security from the Credit Balance. It really depends on the situation of each employer.