April 15, 2021
Contribution backfilling is a powerful strategy that business owners may use in a variety of situations. This article will provide Defined Benefit Plan context for understanding, explain the concept of contribution backfilling, and examine several situations where backfilling in a Defined Benefit Plan may be beneficial.
A Defined Benefit Plan is a type of retirement arrangement. Importantly, only a business may sponsor a Defined Benefit Plan. In general, an individual may not set up a Plan unless they are self-employed.
Although the Defined Benefit Plan is in the same “family” as the 401(k) Plan, there are important differences between the two arrangements. We will discuss these differences in the next two sections of this article.
The annual contribution limit and the ultimate retirement benefit are determined differently for 401(k) and Defined Benefit Plans.
For example, the ultimate retirement benefit in a 401(k) Plan depends on the level and timing of contributions, as well as the investment returns in the retirement account. Specifically, the higher the contributions, the sooner they are deposited, and the better the investment returns, the larger the 401(k) account balance will be at retirement.
On the other hand, retirement benefits in a Defined Benefit Plan are specified by formula, and the contributions are calculated each year such that Plan assets are projected to be adequate to pay retirement benefits. This is in contrast to a 401(k) Plan where the contributions and investment returns determine the retirement benefit. In a Defined Benefit Plan, it is exactly the opposite; the retirement benefit is predefined, and that drives the annual contributions.
Moreover, the retirement payout limit in a Defined Benefit Plan is large. For example, it may be as high as $2.9 million at age 62. Additionally, the benefit may be funded quickly (in only 10 years). That means that an employer could contribute ~$230,000 per owner per year to achieve the payout limit, assuming a 5% per year investment return. Thus, annual contributions in a Defined Benefit Plan may be substantially higher than allowable 401(k) contributions.
401(k) Plans and Defined Benefit Plans have different funding requirements, and they also may be structured differently.
Of course, the required contribution in a Defined Benefit Plan may vary from year to year. In fact, for employers who overfund their Plan, the requirement often is significantly lower than prior year contribution targets.
Another important difference between 401(k) and Defined Benefit Plans is the way in which assets are held and invested. Participants in a 401(k) Plan generally have their own account in which they direct the investments. However, in a Defined Benefit Plan, the assets must be pooled. Additionally, the funds are managed by the employer, not the participants.
Thus, in a Defined Benefit Plan, you have individual retirement benefits that are “backed” by a pooled asset account. What’s more, in almost all instances, the value of the aggregate benefits will not equal the value of the assets backing those benefits. In fact, within certain guidelines, the employer is allowed to underfund or overfund the Plan. Thus, an employer may front-load or back-load contributions to better accommodate their situation.
As mentioned, a Defined Benefit Plan may pay each participant a single sum distribution of up to $2.9 million at age 62. However, this limit is not accrued immediately. Rather, the limit accrues over a 10-year period beginning with the Plan’s effective date. Thus, for an owner-only Plan, the maximum payout of $2.9 million only may be achieved if the Defined Benefit Plan has been effective for at least 10 years.
Let’s take an example. Suppose an owner is 52 years old and will retire at age 62. If she adopts a Plan for the current year, the Plan will have been effective for 10 years at age 62. This will allow for a lump sum payout as high as $2.9 million. Alternatively, if the owner delayed the Plan adoption such that it’s not effective until the following year, at retirement, she only would have participated in the Plan for 9 years. As a result, her maximum payout only could be as high as ~$2.6 million ($2.9 million maximum x 9 years of participation / 10-year requirement).
As you can see, the Plan’s effective date has important implications.
In fact, by maintaining the Defined Benefit Plan longer, even when contributions are not fully utilized, the owner retains the option of a larger retirement payout and higher annual contributions in the future. This is the concept of contribution backfilling.
Put another way, backfilling a Defined Benefit Plan is the action of creating “space” in the Plan, not needed in the current year, then filling that excess capacity with larger contributions in the future.
So how would backfilling a Defined Benefit Plan work in practice? We will cover the following situations where backfilling may be advantageous.
The first situation occurs when a business owner already has maximized his or her 401(k) for the year, leaving limited capacity to make a Defined Benefit contribution.
For example, suppose a one-person business is taxed as a Corporation. In 2020, the business pays the owner a salary of $150,000. Additionally, the business sponsors a Solo K Plan to which the owner deferred $26,000 as an employee contribution. The business also made a 401(k) employer contribution of 25% of the owner’s compensation, or $37,500, for a total 401(k) contribution of $63,500 for 2020.
Now, suppose that the owner discovers the advantages of a Defined Benefit Plan during 2021. He or she realizes that the 2020 contribution available in a Defined Benefit Plan is significantly higher. However, because the 401(k) employer contribution was 25% of the owner’s compensation, the Defined Benefit maximum contribution is substantially reduced.
That’s because if the 401(k) employer contribution exceeds 6% of compensation, then the total employer 401(k) and Defined Benefit contributions are limited to only 31% of compensation. In this particular situation, that only would provide a 2020 deductible Defined Benefit contribution of $9,000 ($150,000 of compensation x 31% limit = $46,500 minus $37,500 in 401(k) employer contributions = $9,000).
So, what options are available?
First, the employer may be able to request a refund of the excess 401(k) contributions such that the remaining contribution is limited to 6% of compensation. This may be possible but does have potential pitfalls that are outside the scope of this article.
Alternatively, the employer may choose to adopt the Defined Benefit Plan during 2021, with a January 1, 2020 effective date, and fund only $9,000 for 2020. By doing this, the owner will have an additional year of participation service. This additional year means that in the future, the excess capacity could be backfilled with larger contributions.
For example, if the owner is able to fund roughly $230,000 per year for 10 years, then, in this case, the owner would be able to fund an additional $221,000 of unused capacity ($230,000 less $9,000) in the next year, or over the course of the next several years. Of course, the allowable “make-up” contribution likely will be higher, because it was invested later.
Suppose a business owner is 57 years old and plans to retire at age 62. Further, suppose that for the current year, the 401(k) contribution maximum is sufficient. However, the business owner expects larger profits starting in the next year and continuing through his retirement. During those highly profitable years, the owner would like to contribute as much as possible to a retirement Plan.
If the owner waits to adopt the Defined Benefit Plan such that it will be effective for the next year, he only will have 4 years of participation in the Plan at his retirement. This means that his maximum payout at age 62 would be ~$1.16 million ($2.9 million maximum x 4 years of participation / 10-year requirement). At an investment return of 5% per year, four annual contributions of ~$270,000 would be permitted.
Alternatively, if the owner adopts the Plan so that it is effective in the current year and makes a nominal contribution for the current year, he will have 5 years of participation at retirement. This increases his payout limit from ~$1.16 million, above, to ~$1.45 million ($2.9 million maximum x 5 years of participation / 10-year requirement). At an investment return of 5% per year, and ignoring the nominal contribution for the current year, four annual contributions of ~$335,000, rather than ~$270,000, would be permitted.
Thus, adopting the Defined Benefit Plan so that it is effective one year earlier, results in an additional $290,000 that may be paid from the Plan.
This third situation occurs when a business owner expects a windfall in the next year. Examples of this include:
In both instances, the owner may adopt a Defined Benefit Plan such that it is effective for the current year, fund it with a nominal amount for the current year, then “double-up” contributions in the following year when the large tax deduction is needed.
In addition to a large, expected windfall in the next year, lumpy profits may create an opportunity for a contribution backfilling strategy. Lumpy profits may occur for an attorney who settles a large case every two or three years but has limited profits between settlements.
In this situation, the attorney may adopt a Defined Benefit Plan for a highly profitable year to allow a large contribution. In the following year, they may amend the Plan such that only a nominal contribution is required between settlements. Once another large settlement is reached, the attorney may increase the Plan formula such that the contribution not only reflects the current year contribution but also the unused “contribution capacity” for prior years. This can result in a very large contribution depending on the age and compensation of the attorney, and the number of years between settlements.
This last situation is when the owner chooses to rotate contributions between their 401(k) Plan and their Defined Benefit Plan. This essentially is a purposeful strategy that has elements of both Situations 1 and 4.
At a high level, the owner rotates between:
This strategy is expected to result in higher overall retirement contributions, because, unlike Defined Benefit Plans, 401(k) Plans cannot be backfilled. Put another way, 401(k) contributions do not roll over to future years.
By interspersing years in which the 401(k) is maximized, you potentially allow additional contributions that could not be made otherwise.
For our example, let’s use a 3-year rotation for 4 cycles. Specifically, we will assume that for two years, the business owner maximizes her 401(k) Plan and makes a nominal Defined Benefit Plan contribution. Then, in the third year, backfills the Defined Benefit Plan to make up for two years of unused capacity and makes a 401(k) contribution such that the Defined Benefit Plan is not affected. This 3-year cycle would be repeated three more times to encompass a 12-year period.
Without contribution rotation, the 401(k) employer contribution is limited every year to 6% of Plan-eligible compensation.
However, with contribution rotation, for 2 of the 3 years, the employer would contribute 25% of compensation to the 401(k) Plan. In the third year, 401(k) employer contributions would be limited to 6% of compensation, and a massive contribution to the Defined Benefit Plan would be made by backfilling.
Assuming Plan-eligible compensation is constant and the required contribution in the Defined Benefit Plan permits the specified rotation, the employer essentially would be picking up 38% of Plan-eligible compensation for every 3-year cycle ((25% employer 401(k) contribution less 6% employer 401(k) contribution) x 2 years). If 4 cycles were completed, this means an additional 152% of Plan-eligible compensation could be contributed to a tax-favored retirement Plan. Of course, in practice, the business owner may deviate from the predefined cycles. For example, the owner may need a larger deduction to be provided in the Defined Benefit Plan in a year when it is not “scheduled” to be taken.
In any case, contribution rotation can be a powerful strategy for maximizing retirement contributions.
The opportunity to backfill Defined Benefit Plan contributions may lead employers to have Plans for a longer duration. This may mean that employers adopt the Plan before they need the capacity provided under a Defined Benefit Plan, or they may choose to maintain the Plan when profits don’t fully support the Defined Benefit maximum.
By being strategic, employers may be able to deposit and deduct hundreds of thousands of dollars in additional contributions.