The 404(o) plan
By Nick Paleveda MBA J.D. LL.M
National Pension Partners
The Pension Protection Act of 2006 created new section 404(o)(2) that allows for a cushion amount to be contributed to a defined benefit pension plan of basically 50 percent of the funding target. This plan is known as a 404(o) plan where the cushion is taken into account in funding a defined benefit plan for a small employer.
Example of the 404(o) plan
John, age 57, has been working for 15 years, has no employees and wants to retire in five years. John generally earns $200,000 a year, but in 2012 will earn $475,000 and wants to put away $275,000 into his pension plan for retirement.
The enrolled actuary creates a formula to provide a monthly benefit of $2,000. The contribution of $275,000 will be enough to cover all five years of benefits and no future contributions are necessary (The author wishes to thank Kevin J. Donovan MAAA, CPA, EA of Pinnacle Plan Design for the example).
The cushion amount
The cushion amount is designed to prevent plans from becoming underfunded and the law applies to large as well as small plans. Small plans will have some limitations that have been written into the Internal revenue Code, where larger plans with more than 100 employees will not have these limitations. However, planning opportunities exist for both plans.
According to the Joint Committee on Taxation:
For taxable years beginning after 2007, in the case of contributions to a single-employer defined benefit pension plan, the maximum deductible amount is equal to the greater of:
(1) the excess (if any) of the sum of the plan’s funding target, the plan’s target normal cost, and a cushion amount for a plan year, over the value of plan assets (as determined under the minimum funding rules); and
(2) the minimum required contribution for the plan year.
The cushion amount for a plan year is the sum of (1) 50 percent of the plan’s funding target for the plan year. In determining the maximum deductible amount, the value of plan assets is not reduced by any pre-funding balance or funding standard account carryover balance.
In determining the cushion amount for a plan with 100 or fewer participants, a plan’s funding target does not include the liability attributable to benefit increases for highly compensated employees resulting from a plan amendment that is made or becomes effective, whichever is later, within the last two years.
Under the bill, in applying the overall deduction limit to contributions to one or more defined benefit pension plans and one or more defined contribution plans for years beginning after Dec. 31, 2007, single-employer defined benefit pension plans that are covered by the Pension Benefit Guarantee Organization insurance program are not taken into account.
Thus, the deduction for contributions to a defined benefit pension plan or a defined contribution plan is not affected by the overall deduction limit merely because employees are covered by both plans if the defined benefit plan is covered by the PBGC insurance program (i.e., the separate deduction limits for contributions to defined contribution plans and defined benefit pension plans apply).
In addition, in applying the overall deduction limit, the amount necessary to meet the minimum funding requirement with respect to a single-employer defined benefit pension plan that is not covered by the PBGC insurance program is treated as not less than the plan’s funding shortfall (as determined under the minimum funding rules).
Is the adoption of a plan considered an amendment?
No, according to IRS Notice 2007-28 Q+A 5. This is important when a client is setting up a new plan and decides to take advantage of the cushion amount. If there is any problem to the (o) plan it is the lack of guidance and case law in the area. If the Supreme Court in a 5-4 decision keeps their hands off of retirement plans, then designs like these will become more important.