Is this legal?

Yes. Defined benefit plans, cash balance plans among them, are written into sections 401(a), 411, 412, 415 and 430 of the Internal Revenue Code and regulated under ERISA, the federal pension law. The Department of Labor counted 46,233 defined benefit plans in its 2023 Form 5500 data, which leaves out one-participant plans.

The Internal Revenue Service enforces the tax rules. The Department of Labor’s Employee Benefits Security Administration enforces the fiduciary and reporting rules. The Pension Benefit Guaranty Corporation (PBGC) insures the plans it covers, and many small plans are not covered: the PBGC excludes a professional service employer’s plan that has never had more than 25 active participants at any time after September 2, 1974, and a plan maintained only for substantial owners, meaning owners of more than 10 percent of the business.

No published IRS audit rate exists for cash balance or defined benefit plans, so no one can promise that a plan avoids an examination or invites one. The IRS does publish the list of documents its examiners request for a cash balance plan, and an ordinary, well-run plan can answer every item on it.

The list starts with the plan document, the trust document and every amendment, the IRS letter that covers the plan document, each Form 5500 with all of its schedules, and any excise tax return the plan filed. A plan on a pre-approved document, with an enrolled actuary and filings made on time, is a plan that can produce each of those.

Yes, one arrangement. The IRS lists deductions for excess life insurance in a section 412(i) or other defined benefit plan among its abusive transactions. A plan whose employer deducts premiums on a life insurance contract with a death benefit more than $100,000 above the participant’s death benefit under the plan is a listed transaction under Rev. Rul. 2004-20.

A taxpayer in a listed transaction must disclose it to the IRS on Form 8886 with the tax return. A sound plan matches its insurance and annuity contracts to the benefits the plan promises, and passes the nondiscrimination tests that apply to every qualified plan.

On February 13, 2004, the Treasury and the IRS issued guidance against specially designed life insurance policies used inside section 412(i) plans. The policies were generally offered only to highly compensated employees, raised the deductible contribution, and were then moved to the employee at a value far below what the policy would soon be worth.

Rev. Rul. 2004-20 holds that a plan cannot be a section 412(i) plan if its insurance and annuity contracts provide benefits at normal retirement age above the benefits the plan itself promises, and that premiums for a death benefit above the plan’s are not deductible when paid. Section 412(i) now carries the number 412(e)(3), and the plan must still be funded exclusively by insurance contracts.

The full answer: What is a 412(e)(3) plan?

The IRS names its own warning signs for plans that hold insurance: premiums above what the plan’s benefits need, life insurance death benefits above the plan’s death benefit, policies offered only to highly compensated employees, and a policy sold or distributed to an employee while its cash value is held artificially low.

• High premiums. The IRS calls a plan abusive when its premiums for life insurance or annuity contracts would, apart from surrender charges, exceed the amount needed to provide the benefits the plan sets out.
• A springing cash value. A contract whose cash surrender value is held down while it leaves the plan, then rises once the employee holds it, must be taxed at its full fair market value.
• Unequal purchase rights. Under Rev. Rul. 2004-21, the right to buy insurance contracts from a plan must be open to every participant on a nondiscriminatory basis.

Ask for the enrolled actuary’s name and enrollment number, then look for that name on the roster of enrolled actuaries in active status that the IRS publishes for the Joint Board for the Enrollment of Actuaries. Only an enrolled actuary may sign Schedule SB, the actuarial report a defined benefit plan files each year with its Form 5500.

Most small plans use a plan document that the IRS has reviewed and issued an opinion letter on, called a pre-approved document. The opinion letter covers the wording of the document. The letter does not approve a plan’s design, its deduction or its tax result.

Some common questions about defined benefit plans rest on a misreading of the law. Each question sits here beside what the statute or the agency actually says, with the source in the last column, so any answer can be checked with a CPA before anyone relies on it.

What a participant has already earned is protected. Section 411(d)(6) of the tax code bars any plan amendment that reduces a participant’s accrued benefit, and the rule protects the owner and every employee alike. An amendment can still reduce or stop future benefit credits after written notice, and the employer can end the plan.

Before an amendment that significantly reduces future benefits takes effect, the plan must give notice at least 45 days ahead, or 15 days for a small plan, meaning one with fewer than 100 participants who have an accrued benefit. When a plan ends, every affected employee’s accrued benefit becomes nonforfeitable to the extent the plan is funded.

The full answer: How do I end the plan?