As Interest Rates Climb, Defined Benefit Plans with Overfunded Benefits Rise

By: Rania V. Sedhom
Sedhom Law Group, PLLC.

Defined benefit plans have long been used by business owners to maximize tax deferred gains. Depending on several factors beyond the scope of this article, an owner can save up to two hundred and sixty-five thousand dollars ($265,000) in a pension plan. The maximum amount permitted to be saved in these plans fluctuates, as determined by the Internal Revenue Service.

With interest rates climbing, defined benefit plans are reaping the rewards. For every 100 basis points interest rates increase, a plan’s liabilities are reduced an average of 13% and the cost of providing the benefit is reduced by approximately 15%. Since March 2022, the Fed increased interest rates by 500 basis points and are poised to increase it again this year. Since then, overfunded benefit plans are commonplace.

For companies with no employees, and whose owners are near retirement or other exit, overfunding can result in a 90% excise tax on the overfunded benefit. A strategic sale of the overfunded benefit to an underfunded plan poses a win-win for all parties involved. Typically the buying plan receives a 20% discount on the monies it is purchasing. Consider the following:

Bob, Chester and Jim are partners in a consulting company they formed 25 years ago. In addition to selling consulting services, they also offer online courses to help businesses grow. Bob, Chester and Jim are in their late 50s and have no employees. They started a defined benefit plan 20 years ago and it now has a balance of $30,000,000. The benefit limit for the 3 partners is $12,000,000. The remaining $18,000,000 is subject to a 90% excise tax. Rather than pay $16,200,000 in taxes, they may, instead, sell their $18,000,000 overfunding to an underfunded plan belonging to another organization for $14,400,000 ($18,000,000 x .80). This presents a favorable scenario for both organizations, relieving the tax obligation of the overfunded plan and a more direct savings for the underfunded plan. The purchase is structured as a stock sale of the consulting company. Bob, Chester and Jim then each receive their proportionate share of the $14,400,000 and pay a long-term capital gain tax.  Assuming their capital gain tax rate is 25%, they each would receive nearly $4,800,000 in addition to their approximate $4,000,000 in retirement benefits.

This scenario is just one example of how the application of an attorney’s advanced understanding of benefit plan regulations can legally minimize tax obligations. Consulting with an attorney with overfunded plan knowledge can, as the illustration evidences, save you millions of dollars in taxation.