April 9, 2019
What is the minimum participation in a Defined Benefit Plan (“DB Plan”)? This is a common question we get from business owners.
To some extent, minimum participation in a Defined Benefit Plan is addressed indirectly in the coverage requirements. However, DB Plans have an additional layer of compliance that needs to be satisfied under IRC § 1.401(a)(26). This requirement has important differences from the minimum coverage standards.
In a Defined Benefit Plan, generally, at least 40% of qualifying employees (but not more than 50) need to receive a meaningful benefit every year. If there are only one or two qualifying employees, typically all of them must receive a meaningful benefit each year.
For example, if an employer had 11 qualifying employees, at least 5 of them would need to receive a meaningful benefit every year. (Forty percent of 11 employees is 4.4 employees; this is rounded up to 5 employees).
If an employer had 500 qualifying employees, then the requirement would be limited to only 50 employees. (Forty percent of 500 employees is 200 employees; however, no more than 50 employees are required to receive a meaningful benefit each year).
Many of our clients are owner-only Defined Benefit Plans. As mentioned above, in these situations, the owner needs to receive a meaningful benefit each year. This is not an issue, because usually owners want their benefit to increase each year. If the owner’s spouse is the only other employee, he or she also needs to receive a meaningful benefit.
As mentioned, every year, an employer is required to provide a meaningful benefit to 40% of qualifying employees (note that the technical term is nonexcludable employees, but we’ll use the term “qualifying employees” to avoid confusion). If an employee is not qualifying, they are not included in the minimum participation calculation.
Take for example an employer with 50 employees where only 30 employees are qualifying. In this situation, the employer would only need to provide a meaningful benefit to forty percent of the 30 employees, which is 12 employees (rather than forty percent of 50 employees, which is 20 employees). Thus, of the 50 employees, a meaningful benefit only needs to be provided to 12 employees. The other 38 employees could be excluded from the Plan assuming nondiscrimination requirements are satisfied.
At a very high level, a qualifying employee is someone who is at least 21 years old and has worked at least one full year of 1,000 or more hours. In reality, the definition of a qualifying employee is much more complicated and nuanced.
If a Defined Benefit Plan is frozen (Plan is amended such that benefits no longer increase), the minimum participation requirement may be automatically satisfied if other conditions are met.
For the required minimum number of employees, benefit increases must be meaningful.
What is considered meaningful for this purpose? According to IRS guidance, benefits to be paid at the Plan’s retirement age need to increase by at least 0.50% of pay.
For example, to be considered meaningful, someone whose compensation is $50,000 per year, needs their annual retirement benefit to increase by $250 year over year. In terms of cost, this is often a nominal amount, especially when compared to the value of the owner’s benefit accrual.
So, how many employees need to receive a benefit increase in a Defined Benefit Plan? For a small business Plan, the answer is 40% of qualifying employees. Of course, if it’s an owner-only or owner and spouse Plan, then everyone must participate. In addition, this requirement must be considered in conjunction with other Defined Benefit regulations, such as nondiscrimination, and top-heavy rules.
In general, a good plan design works to achieve the objectives of the business owner while efficiently satisfying Defined Benefit requirements. Often, this is complex, but attainable, for the high-income business owner.
Curious if a Defined Benefit Plan would significantly reduce your taxes while you fund for your own retirement? Contact us today at (480) 795-8256 or at email@example.com.