The stock market has been up and down throughout 2022 so far – more down than up. A number of qualified retirement plan clients have asked us about making their 2022 plan year contributions early, the goal being to “buy the dip.”
First, let’s define what it means to make a plan contribution “early.” Generally, it means depositing the contribution before there is as much certainty as possible that a limit will not be violated or before there is an opportunity to reassign the contribution to a later year if needed.
For both defined contribution and defined benefit plans, the safest time to deposit a contribution attributable to a given year is after the year is over. A contribution deposited early enough in a year may be applied either to the previous year or the current year. (Specifics on contribution deadlines may be found here.) By waiting until after the year has ended, not only will all of the information be available for the most reliable calculations, but should something go wrong there is the opportunity simply to reclassify a contribution from the prior year to the current year and then reduce the current year contribution accordingly. If the contribution attributable to a year is made during that year, there is no opportunity to reclassify any part of the contribution in this way, and the plan sponsor is more likely to be stuck with a nondeductible or otherwise erroneous contribution.
Here is a simple example. Mary owns a business (solo practice) and thought she was going to pay herself $120,000 in 2021. The maximum deductible contribution to a DC plan is 25% of pay. Mary went ahead and made her profit sharing contribution of $30,000 in December of 2021. For one reason or another, Mary paid herself only $100,000 in 2021. The maximum deductible contribution is therefore only $25,000. She now has a nondeductible contribution of $5,000. There is no opportunity to easily apply the extra $5,000 contribution to the 2022 tax year. Had she waited until January 2022 to make her $30,000 deposit, she could have applied the $5,000 that was not deductible in 2021 toward the 2022 contribution. Whether the $5,000 would be deductible in 2022 would depend on Mary’s pay for 2022, but at least she would have the rest of 2022 to position things so that the contribution is deductible.
Not everyone wants to wait until the year is over to make their contributions. Sometimes, plan sponsors want to make deposits as early as possible so the contributions have more time in the market. In some cases, like early 2022 or especially after the pandemic started in March 2020, they want to pounce immediately after a market drop in order to enjoy a potential rebound.
Is this a good idea or not? With DC plans, the example above shows that the deductible contribution limit may be more easily violated if an early contribution is made. Other errors, such as annual addition limit violations or letting an employee into the plan too soon, are similarly harder to overcome.
DB plans have a different set of questions that need to be asked:
Will the contribution fall within the min-max range for the year? Each year, a DB plan has a minimum required contribution and a maximum deductible contribution determined by the enrolled actuary. This contribution range is usually communicated in a valuation report. Valuation reports can be prepared at different times across the annual work cycle. Many are prepared after the plan year has ended. Some are produced during the plan year, but toward the middle or end of the year. Very few are prepared just one or two months into the year. Those are usually large corporate plans.
It is likely that someone asking about making a 2022 DB contribution in January or February 2022 has not had the 2022 valuation prepared for their plan. For that matter, the 2021 valuation might not even be done yet. Assume a plan sponsor asks in February 2022 whether it is “safe” to contribute $200,000 to its DB plan for 2022. The actuary will either have to say no, it’s not, or he will have to review the prior year report and informally extrapolate those results to the current year. If the actuary reasons that the maximum deductible contribution will be, say, $250,000 or more, he might feel comfortable in saying $200,000 could be contributed now, despite there being no official valuation report yet.
It would seem that when the valuation report is ultimately released and it shows a maximum contribution of at least $200,000, then $200,000 could be contributed right then and there. Maybe so, but there is always the possibility that a mistake could be uncovered later, which suggests again that waiting until the year is over to contribute is safest. But the plan sponsor and actuary may be willing to agree that the likelihood of such an error is low.
Does the self-employed individual have adequate earned income to be able to deduct the contribution? This is a question only for self-employed individuals. Self-employed individuals are able to make large deductible DB plan contributions without having much current income. This is very different from the DC plan situation where large contributions require large current income. It would not be unfathomable for a self-employed person to be able to contribute $200,000 to a DB plan while having only, say, $10,000 in earned income in a particular year. However, a plan contribution deduction cannot exceed the net profit on Schedule C of Form 1040 minus the one-half self-employment tax deduction. Therefore, if a self-employed person wants to make an early contribution to a plan, he needs to be sure that there will be adequate earned income in that year to avoid having a nondeductible contribution.
Corporations may also make large deductible DB contributions even if the plan participants do not have high current income. Whether corporations are able to take a loss resulting from a DB contribution is beyond the scope of this article.
Does the plan sponsor mind fully funding the plan sooner than intended? There are no limits on the level of assets one may accumulate in a DC plan or similar arrangement like an IRA. There are, however, limits on what an individual may be paid from a DB plan. This is why a conservative asset allocation is often recommended for DB plans. An aggressive allocation could lead to significant underfunding, which would result in additional required contributions, or significant overfunding, which could lead to lower contributions or eventually excise taxes.
“Buying the dip” is a way to make good on the buy half of the old adage, “buy low, sell high.” A plan sponsor will look like an investment genius if the market pops back up after using this approach. But any outsized returns could limit future year deductible contributions. On one hand, it may seem like a bad thing if the plan to which you hoped to contribute $200,000 or $300,000 annually gets fully funded sooner than you thought. On the other hand, the tax rate is less than 100%, so paying taxes on more income because your plan investments did so well doesn’t seem like such a bad tradeoff. There are worse problems in the world, although finding out you have to pay additional taxes for any reason is not fun.
In summary, making early contributions to a qualified plan gives plan assets more time in the market and can lead to strong returns if the timing is right. There are risks to contributing early. Plan sponsors should be aware of these risks and decide if the benefits outweigh them.