Magazine article The CPA Journal

The Revitalizaiton of the Defined Benefit Pension

Magazine article The CPA Journal

The Revitalizaiton of the Defined Benefit Pension

Article excerpt

After the passage of the Omnibus Budget Reconciliation Act of 1993 (OBRA '93), which limited eligible compensation for purposes of the qualified plan and resulted in a reduction of tax rates, the number of firms adopting defined benefit plans declined dramatically.

With a maximum Federal tax bracket of 28% plus a 5% surtax in some instances (down from 50%), many business owners, especially those involved in closely held businesses, were advised to use the defined contribution plan approach, despite the $30,000 annual limitation on contributions.

In addition, the expanded use of 401(k) plans could relieve them, in many situations, of the necessity to adopt any other qualified plan. A plan with a matching contribution could be less costly than other qualified plans.

The business owner would either participate in the 401(k) plan, if the plan met the various discrimination tests, or the owner would invest his or her own funds outside the plan. The tax incentives were not sufficient.

With the passage of OBRA '93, came the increase in the rates to 39.6%, and in some cases higher, with the increase in Medicare taxes to an unlimited 1.45% on all compensation and a phaseout of deductions.

In addition, for plan years beginning in 1994, eligible annual compensation for qualified plan purposes was decreased to $150,000 (indexed in multiples of $10,000). As a result, 401(k) plans for executives lost some glamour, because in order to defer the maximum $9,240 in 1994, (6.16% of allowable compensation), an average deferral percentage for nonhighly compensated employees of 4.16% was required. In many cases, this was not attainable. The $9,240 maximum remains for 1995.

As a result, after OBRA '93 many firms decided to install nonqualified executive compensation plans or to reexamine the defined benefit plan, especially, for the executive who was 45 years and older. The nonqualified plan offers a number of advantages to selected executives in various corporations. But to the owner executive doing business as a partner or a sole proprietor, cash flow and the effect on the balance sheet might be too drastic. In addition, there would be no tax deduction in the nonqualified deferred compensation plan until the funds are made available to the executive beginning in some future year.

Under the proper circumstances, the defined benefit plan became the obvious solution. It offers a deductible contribution and a specific retirement benefit at a specific age. Factors that can be taken into consideration in its design are age, length of service, preretirement death benefits, post-retirement death benefits through a joint and survivor annuity, terminated employee benefits, disabled employee benefits, and loans (in C corporations).

Many business advisers, CPAs, attorneys and other financial planners, consider the defined benefit plan as inflexible, especially as to funding. However, there are many courses of action that may be taken in designing a dined benefit plan. For example, the plan year may begin toward the end of the fiscal year, for example, December 1, 1995, for a calendar year entity. Assume that the defined benefit contribution is calculated to be $75,000. The usual date for making the contribution would be the due date of the income tax return for the sponsoring entity plus any extensions of time for filing. Assume that the employer has a temporary cash shortage which would not be relieved by September 15th of the following year, but that a contribution of $50,000 could be deposited by September 15, 1996. The employer would be permitted a deduction of $50,000 on the 1995 tax return. …

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