It’s human nature to take action as a deadline approaches. For example, why do you think CPAs are busier in April than February? Not surprisingly, it’s the same for clients setting up a Defined Benefit Plan. Historically, we’ve seen Defined Benefit inquiries and setups significantly increase near the statutory due date.
In some instances, this makes sense. The latter part of the year is “tax planning” season, after all, where CPAs turn their attention to reducing taxes before the year closes. It’s also reasonable for a new business to better understand their year’s income before adopting a retirement Plan.
However, for businesses with more predictable profits, early implementation (and funding) has advantages. Most notably, acting sooner provides a lot more flexibility, and for small business owners, flexibility is key.
How does setting up and funding a Defined Benefit Plan early in the year create flexibility?
First, rather than paying for the Plan after benefits have been “fixed”, employers have the opportunity to amend the benefits as they make funding decisions.
Second, funding the Plan on an earlier schedule provides more time in subsequent years if cash is tight.
Third, it may permit the employer to amend an existing 401(k) Plan. This often is needed to more efficiently pass nondiscrimination testing.
The bottom line is that employers have much more flexibility when they adopt a Plan earlier in the year. We will explore each of these three items in more detail. However, first, we need to provide some context.
An important characteristic of Defined Benefit Plans is that benefits cannot be retroactively “cutback”. For example, it’s common for a Plan to provide participants a benefit accrual for that year after they work 500 or even 1,000 hours. However, once employees cross the hour’s threshold and accrue a benefit, the law protects the benefit. The employer cannot cut it back. Importantly, “anti-cutback” legislation applies to all participants including business owners.
While employers cannot cutback past benefit accruals, they may reduce or even freeze future accruals. In the case of a freeze, participant benefits no longer increase. They stay fixed as of the Plan freeze date.
Why do accruals matter in the context of this article? As you will see in the next section, accruals drive required contributions. Funding ahead of the year’s accruals provides the employer an opportunity to reduce cash requirements at the time of funding.
As mentioned, Defined Benefit Plans generally require annual contributions to sufficiently fund benefits. If the employer does not meet minimum obligations, the repercussions can be significant. Thus, the employer should take steps to reduce the risk of missing required contributions. As we will show, early adoption and funding of the Defined Benefit Plan significantly decrease this risk.
The largest component of the minimum requirement often is the value of benefit increases expected during the year. Thus, once participants work the required number of hours, they accrue a benefit for the year and essentially “lock in” that year’s contribution requirement.
As you can imagine, by adopting and funding the Plan early in the year, the employer can evaluate the affordability of funding requirements under the current Plan. If cash is tight, the business owner may amend the Plan before employees earn benefit accruals, reducing or even eliminating that year’s funding requirement.
On the other hand, employers who adopt the Plan late in the year, usually, by default, consistently fund the Plan after participants have passed the hour’s threshold. This results in very little flexibility. In this case, employers are evaluating the affordability of that year’s Plan cost after the obligation is fixed.
What’s more, some employers fund the Plan on the last possible date, which is September 15th of the following year. In this situation, two years of contributions have been “fixed” (the prior year and the current year). For example, if the employer funds the Plan on September 15, 2024, participants have accrued benefits for both 2023 and 2024. Freezing the Plan at that date wouldn’t impact contributions until the contribution due on September 15, 2026 (two years after the Plan is frozen).
As discussed above, funding the Plan earlier in the year allows the employer to evaluate affordability and required contributions at the time of funding. Additionally, early funding allows an option to delay contributions if needed.
For example, assume an employer adopted and funded a Defined Benefit Plan for 2023 in March 2023. After a couple of years, in 2025, they run into cash constraints. Since the employer can fund the 2025 contribution as late as September 15, 2026, they may delay funding by 1-1/2 years and still meet the funding requirement. Alternatively, they can amend the Plan, as discussed above, to freeze benefits before another year of accrual.
Conversely, employers who fund the Plan on the latest possible date cannot delay funding if cash is tight. They already are operating at the deadline with no flexibility to delay funding!
If a business has employees, generally the cheapest way to pass nondiscrimination testing is through a DB/DC Combo Plan. A DB/DC Combo Plan is actually two separate Plans. In this arrangement, an employer uses both a 401(k) and a Defined Benefit Plan together to meet testing requirements, These requirements ensure non-owners and non-highly compensated employees receive their “fair share”.
In general, it’s cheapest for the employer to overweight benefits for the non-highly compensated in the 401(k). Conversely, most of the owners’ benefits would be provided in the Defined Benefit Plan. This usually is the most efficient way to pass testing.
However, if the employer adopts the Defined Benefit Plan later in the year, issues may occur. For example, it’s common for employers to have an existing 401(k) Plan that their TPA designed on a standalone basis. In other words, it will not pair well with a Defined Benefit Plan.
This is not an issue if the employer adopts the Defined Benefit Plan early in the year. They simply can amend the 401(k) Plan before employees earn an employer-provided benefit for that year. Conversely, if the Defined Benefit Plan is adopted later in the year, the 401(k) Plan cannot be changed until the next year. This creates constraints (and usually more cost) to pass testing.
As an example, 401(k) Plan designs often allow for a discretionary Profit Sharing allocation to be divided between the participants as an equal percentage of pay. So-called pro-rata allocations may prevent an efficient design, because both owners and non-highly compensated employees receive the same allocation as a percentage of pay. But that’s generally not the best 401(k) design when it’s coupled with a Defined Benefit Plan. As mentioned, it’s usually advantageous to overweight 401(k) benefits to non-highly compensated employees and underweight 401(k) benefits to owners.
Having to provide equal benefits in the 401(k) means non-highly employees need a higher, more expensive, benefit in the Defined Benefit Plan. This may even make the Defined Benefit Plan cost prohibitive until the next year so that the employer loses a year of Defined Benefit deductions. The solution? Simply adopt the Defined Benefit Plan earlier in the year while the employer can amend the existing 401(k) Plan.
The SECURE Act of 2019 created many opportunities for Defined Benefit Plans. One of the provisions, however, is a double-edged sword.
Specifically, before the SECURE Act, employers had to adopt Defined Benefit Plans by the end of the tax year for which the deduction applied. For example, to receive a 2019 deduction, employers with calendar tax years had to set up the Plan by December 31, 2019. The SECURE Act extended this deadline to the date the employer files the applicable business tax return. Starting in 2020, for example, a business owner could adopt a Plan in September 2021 and receive a deduction for 2020.
This provision is helpful because business owners often don’t know they need a Plan until their CPA is working on their tax return. Under the new law, an employer could adopt a Defined Benefit Plan for the prior year and significantly reduce taxes.
Unfortunately, we expect some employers to adopt the Plan as late as September of the following year. In addition, to several logistical issues that we won’t discuss here, adopting a Plan that late puts the employer on a delayed funding schedule. As discussed above, this results in the employer being unable to affect funding requirements for two years and provides no flexibility to delay contribution timing when needed.
All being equal, adopting and funding a Defined Benefit Plan early in the year provides many advantages, most notably, flexibility. While there may be compelling reasons for adopting Plans later in the year, employers should not ignore the benefits of early adoption.