A sponsor with an overfunded defined benefit plan has options that fall into a small set: stop or reduce contributions, richen the benefits, de-risk the plan through lump sums or annuity buyouts, move a slice of surplus to a retiree health or life insurance account under Section 420, terminate the plan and take an employer reversion, or leave the cushion in place. Each option has a funding threshold, a tax consequence, or a procedural requirement attached to it, and the aggressive ones carry excise taxes designed to keep them rare.
When a Plan Actually Counts as Overfunded
A defined benefit plan is overfunded when its assets exceed the present value of accrued benefits. The ratio is the funding target attainment percentage, or FTAP; above 100% is surplus, below is shortfall. An enrolled actuary sets the “funding target” each year under the framework the Pension Protection Act of 2006 locked in, using prescribed interest rate and mortality assumptions that often produce a higher liability than corporate accounting figures suggest.
Being just over 100% is a paper surplus and buys almost no flexibility. Several of the strategies below unlock only at 110%, 120%, or 125% funding, so the practical menu depends on how deep the cushion runs.
Take a Contribution Holiday
The most immediate use of surplus is to stop funding the plan. When assets exceed the funding target, the minimum required contribution drops to zero, and the sponsor can go on what is informally called a contribution holiday. Cash that would have gone into the trust can be redirected to operations, debt paydown, or shareholder returns. The holiday lasts as long as the surplus does; a market downturn or a demographic shift can end it.
Sponsors who do contribute more than the minimum in a given year can elect to create a prefunding balance under IRC Section 430(f). That balance earns interest at the plan’s actual rate of return and can be applied against future minimum required contributions, effectively banking today’s payment for later use.1eCFR. 26 CFR 1.430(f)-1 – Effect of Prefunding Balance and Funding Standard Carryover Balance It gives a middle path between a full holiday and steady funding, and can absorb some of the volatility risk that comes with going cold turkey.
Improve Participant Benefits
Surplus can be spent on the participants themselves. Typical improvements include a cost-of-living adjustment for retirees whose purchasing power has eroded, or a higher accrual rate so active employees build larger pensions going forward.
Any enhancement is adopted as a formal plan amendment and is irrevocable once in place. The actuarial value of the new benefits consumes part of the surplus and reduces the FTAP. Sponsors also use benefit improvements strategically during a plan termination to qualify for the lower excise tax rate on any remaining reversion, discussed below.
De-Risk the Plan
A cushion gives sponsors the room to move obligations off the corporate balance sheet without triggering new contribution requirements. Two approaches do most of the work.
Lump-Sum Windows
The sponsor opens a time-limited window, typically 60 to 90 days, during which terminated vested participants can elect a one-time lump sum instead of a future monthly pension. Each participant who takes the offer removes their liability from the plan entirely. Plans below 80% funded can’t pay lump sums under the Pension Protection Act’s benefit restriction rules; overfunded plans face no such barrier.
Annuity Buyouts
The sponsor buys a group annuity from an insurance company, which then takes over paying benefits for a specified group of retirees. Investment risk and longevity risk shift to the insurer. The premium comes out of plan assets, and the surplus lets the sponsor fund the purchase without a new contribution.
Both moves permanently reduce the plan’s headcount and liability. Sponsors with a large enough cushion combine them: lump sums for deferred vested participants, annuities for current retirees. That winds down the risk profile without a formal termination.
Transfer Surplus Under Section 420 to Retiree Health or Life Insurance Accounts
IRC Section 420 is a narrow exception that lets sponsors move excess pension assets into a retiree health benefits account or a retiree life insurance account without triggering the reversion excise tax. The transferred funds pay current retiree health or life insurance costs, and the transfer is excluded from the employer’s gross income.2Office of the Law Revision Counsel. 26 USC 420 – Transfers of Excess Pension Assets to Retiree Health Accounts
The requirements are strict. A standard qualified transfer requires assets to exceed 125% of the sum of the funding target and target normal cost.2Office of the Law Revision Counsel. 26 USC 420 – Transfers of Excess Pension Assets to Retiree Health Accounts Only one transfer per taxable year qualifies, though a single year’s transfer can be split between a health account and a life insurance account and still count as one. The amount is capped at what the plan reasonably expects to spend on qualifying retiree benefits during the transfer period.
After a transfer, the employer must hold retiree health spending at least at the pre-transfer level for a cost maintenance period of five taxable years starting with the transfer year.2Office of the Law Revision Counsel. 26 USC 420 – Transfers of Excess Pension Assets to Retiree Health Accounts Cutting benefits during that window triggers penalties. Any transferred money that goes unused must return to the pension plan, where it becomes an employer reversion subject to a 20% excise tax.
Qualified Future Transfers
A qualified future transfer spreads the transferred amount over a period of consecutive taxable years, at least two and no more than ten, beginning with the transfer year. The funding threshold is slightly lower: assets must exceed 120% of the funding target plus target normal cost.2Office of the Law Revision Counsel. 26 USC 420 – Transfers of Excess Pension Assets to Retiree Health Accounts It gives sponsors with ongoing retiree medical obligations a longer runway.
SECURE 2.0 De Minimis Transfers
SECURE 2.0 added a de minimis category with a lower funding bar. A plan that has been at least 110% funded for the current year and the two preceding years can transfer up to 1.75% of plan assets to a retiree health or life insurance account, even if the plan doesn’t meet the 125% standard threshold.2Office of the Law Revision Counsel. 26 USC 420 – Transfers of Excess Pension Assets to Retiree Health Accounts The trade-off is a seven-year cost maintenance period instead of five. SECURE 2.0 also pushed the overall expiration date for Section 420 transfers to December 31, 2032.
Terminate the Plan and Take an Employer Reversion
The most aggressive option is an employer reversion: removing surplus from the plan and taking it as corporate cash. It’s only available on a formal standard termination, and the tax structure is built to make it a last resort.
The Tax Hit
IRC Section 4980 imposes a 20% excise tax on any employer reversion from a qualified plan. That rate jumps to 50% unless the employer takes one of two steps: establish a qualified replacement plan that covers at least 95% of the terminated plan’s active participants, or amend the terminated plan to give a pro rata increase in accrued benefits.3Internal Revenue Service. Revenue Ruling 2003-85
On top of the excise tax, the reverted amount is included in the employer’s gross income under IRC Section 61.3Internal Revenue Service. Revenue Ruling 2003-85 At a 21% corporate tax rate, a sponsor paying the 50% excise tax and income tax keeps roughly 29 cents of every dollar reverted. At the reduced 20% rate, the combined federal burden takes about 37 cents on the dollar. Those numbers are the point.
Getting to the 20% Rate
To qualify for the lower rate through a replacement plan, two conditions apply. At least 95% of the active participants from the terminated plan who remain employed must become active in the replacement plan. And the employer must transfer 25% of the maximum potential reversion directly from the terminated plan into the replacement plan before pulling any money out.3Internal Revenue Service. Revenue Ruling 2003-85 That transferred amount isn’t taxed as income and isn’t treated as a reversion.
The alternative path is to amend the terminating plan within 60 days before termination to give a pro rata benefit increase effective at termination. The value of the increase reduces the reversion, and what remains gets taxed at 20% instead of 50%.
What Termination Actually Requires
Reversion requires a standard termination, meaning the plan must hold enough assets to satisfy every benefit obligation. The sponsor sends a Notice of Intent to Terminate to participants at least 60 and no more than 90 days before the proposed termination date, files a Standard Termination Notice (Form 500) with the PBGC along with an actuary’s certification of sufficiency, distributes all accrued benefits either as lump sums or through irrevocable annuity contracts, and files a Post-Distribution Certification (Form 501) once the plan is wound down.4Pension Benefit Guaranty Corporation. Standard Terminations Between notice periods, actuarial work, benefit settlements, and PBGC review, the process commonly runs over a year. The reversion happens last, after every participant’s benefits are secured.
Keep the Surplus as a Cushion
Doing nothing is often the strongest move. A large surplus buffers the two biggest risks in a defined benefit plan: investment losses and participants living longer than the mortality tables assumed. A plan at 120% today can absorb a real market correction without dropping below 100% and triggering mandatory contributions or benefit restrictions.
Holding the cushion also preserves optionality. A well-funded plan can pursue de-risking transactions or benefit improvements on the sponsor’s own timeline instead of being forced into them by regulatory pressure. The surplus keeps earning investment returns, potentially funding future obligations without any additional employer contributions. For sponsors with long time horizons, leaving the surplus alone often produces better outcomes than the more active strategies.