DEDUCTIBILITY OF PENSION PLAN CONTRIBUTIONS

Excessive contributions to a pension plan fund, if they are allowed to be deducted, will accelerate the employer's tax deduction and thereby increase the tax benefit of the qualified plan beyond what is considered appropriate. To prevent this, there are specific limits on the amount of pension plan contributions that an employer can deduct in a given plan year.

Unlike the deduction limit for profit-sharing plans, which is 15 percent of payroll ), the deduction limit for pension plans is based on actuarial considerations. For a given plan year, an employer can deduct contributions to a pension plan up to a limit determined by the largest of three amounts [Code Section 404(a)(1)].

1. The amount necessary to satisfy the minimum funding standard for the year.
2. The amount necessary to fund benefits based on past and current service on a level funding basis over the years remaining to retirement for each employee. However, if the remaining unfunded cost for any three individuals is more than 50 percent of the total of the unfunded costs, fundings for those three individuals must be distributed over a period of at least five taxable years.
3. An amount equal to the normal cost of the plan plus, if there is a supplemental liability, an amount necessary to amortize the supplemental liability in equal annual payments over a ten-year period.

In determining the applicable limitation, the funding methods and the actuarial assumptions used must be the same as those used for purposes of the minimum funding standards. Furthermore. the tax deduction for a given plan year cannot exceed the full funding limitation that was discussed earlier. Thus, there is little incentive for the employer to contribute beyond the full funding limitation.

Although these limits are expressed in actuarial language, the implications are relatively easy to understand. First of all, if the plan is funded on the basis of individual insurance contracts, the second limit will generally be the one applicable to the plan because most such contracts have premiums determined on the basis of level funding for the years remaining until retirement for each employee. On the other hand, plans funded with group contracts and trust funds using a variety of actuarial methods and assumptions will generally be governed by the third alternative limit.

Note that this limit specifies the maximum deductible amount. The amount required to be contributed under the minimum funding standard as applied to the plan may be somewhat less than this limit. Therefore, in a given plan year, the employer's actual contribution and deduction may be less than the maximum limit that applies. This is one of the reasons why a defined-benefit plan with a group pension contract or trust fund can be relatively flexible for the employer. Between the minimum limit required by the minimum funding standards and the maximum deductible limit discussed earlier, there may be a relatively comfortable range of contributions that can be adjusted according to the employer's specific financial situation.

Technically, the rules previously stated apply to both defined-benefit and defined-contribution pension plans. However, for defined-contribution plans, the minimum funding standards are satisfied whenever the employer makes the annual contributions specified by the plan document. In other words, the limit on the amount deductible under a defined-contribution pension plan is simply the amount specified in the plan document. For example, the plan document in a money-purchase plan might require that each year the employer must contribute an amount equal to 6 percent of each employee's compensation to that employee's account. The total of such contributions would then be both the amount required by the minimum funding standard and the maximum amount deductible.

If an employer has a combination of defined-benefit and defined-contribution plans covering the same employee or employees, a percentage deduction limit applies. The deduction for a given year cannot exceed the greater of 25 percent of the common payroll (compensation of employees covered under both plans) or the amount required to meet the minimum funding standard for the defined-benefit plan alone. This provision has its greatest impact on highly compensated employees.

Penalty for Nondeductible Contributions
Generally, there is no advantage in contributing more to a plan than is deductible, because not only is the deduction for the excess unavailable but under Code Section 4972, a 10 percent penalty is imposed on the nondeductible portion of the contribution, with some exceptions. However, if nondeductible contributions are made, they can be carried over and deducted in future years. The deduction limit for future years, however, applies to the combination of carried-over and current contributions.

Timing of Deductions
The rules for timing of contributions and deductions for qualified plans are relatively favorable. Contributions will be deemed to be made by the employer for a given taxable year of the employer, and will be deductible for that year, if they are made by the time prescribed for filing the employer's tax return for that year, including extensions. For example, a corporation using a calendar year could contribute to the plan for 2001 as late as September 15, 2002 (the basic tax filing date of March 15, plus the maximum six-month extension). The rules for timing of contributions and deductions are the same for both cash and accrual-method taxpayers; there is no advantage for this purpose in using the accrual method.