Cash balance plans and 401(k) profit-sharing plans offer tremendous flexibility for sole proprietors. Two key contribution limitations—known as the 6% and 31% rules—help determine how much can be contributed.
Most plans typically follow the 6% rule, but the 31% rule can be beneficial for younger business owners aiming to maximize contributions. Unfortunately, many advisors and administrators often overlook the 31% rule.
In this post, we will discuss how these rules work together. We will also show you why, contrary to popular opinion, the 31% rule often works best for younger, high-income sole proprietors. Let’s jump in!
Some Background
One of the most popular plan designs is combining a 401(k) profit-sharing plan with a cash balance plan. When you combine two different plans together, the IRS will either prohibit the combination or limit the contribution amounts.
The good news is that the IRS does allow a cash balance plan to be combined with a 401(k) profit-sharing plan. However, they impose limitations on the contributions.
The IRS allows the 401(k) employee deferral to be made without any limitations. This is because it is an “employee” contribution and not an “employer” contribution.
But when it comes to the cash balance plan contribution and the profit-sharing contribution, the IRS has two separate limits. One is the 6% limit, and the other is the 31% limit.
What is the 6% limit?
The IRS states that as long as either the profit-sharing contribution or cash balance contribution is limited to 6% of “deemed” compensation, the contribution to the other plan will have no limitation (except for standalone limits).
Said differently, if the profit-sharing is 6% of the deemed wage, the cash balance plan can be as high as the actuarial limit. But this rule relates to either plan. So, you may also contribute 6% of your deemed compensation to the cash balance plan and then fund the profit sharing up to the maximum allowable annual addition limit.
What is the 31% rule?
The 31% rule states that the combined contributions from the cash balance plan and the 401(k) profit-sharing plan cannot exceed 31% of the deemed compensation. You can mix and match those contributions, so long as they do not exceed the 31%.
To maintain compliance with the two plans, the IRS requires that you meet either the 6% rule or the 31% rule. You don’t need to pass both tests. As long as you meet one of those rules, the combination is allowed (subject to other testing).
When applied properly, these guidelines can significantly boost tax-deferred savings—especially for self-employed individuals under age 40 who have long time horizons to grow retirement assets.
Why 6% Profit Sharing Often Produces the Highest Overall Contribution
In most situations, the 6% rule will yield the highest overall combined contributions. When a cash balance plan is paired with a 401(k) profit-sharing plan, the 6% profit-sharing allows actuaries to calculate the maximum allowable cash balance contribution.
For older business owners, this will generate a substantial cash balance contribution, that would be lower for younger business owners. However, the relationship between profit-sharing and cash balance contributions is nuanced.
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For many older, high-income business owners, this ensures the highest overall tax-deductible contribution. The 6% rule leverages both plan types efficiently maximizing retirement savings while maintaining compliance with IRS annual limits.
Understanding Net Income vs. Deemed Compensation
A critical step in calculating contribution limits for sole proprietors is distinguishing between net income and deemed compensation. Net income represents the total profit after business expenses, as reported on Schedule C of the tax return. However, retirement plan contributions are based on the “deemed compensation,” which adjusts net income to approximate W-2 compensation for contribution purposes.
The deemed compensation is an amount lower than the business net income. Net income will include the deemed compensation, half of the self-employment taxes, and the retirement plan deduction itself.
As a result, this amount is lower than net income but serves as the official basis for calculating contribution limits under qualified plan rules. For 2025, the maximum deemed wage recognized by the IRS is $350,000. Any compensation above this threshold does not increase contribution limits.
This means a sole proprietor earning $1 million will still have a deemed wage capped at $350,000. All plan contribution percentages—whether 6% or 31%—are applied to this capped amount, not total profit. Understanding this distinction is essential for properly structuring defined benefit and profit-sharing contributions.
Why the 31% Rule Benefits Younger Business Owners
The reason why the 31% rule works so well for younger business owners is due to how actuarial tables function. As a general rule, the higher your compensation and the older you are, the more you can get into a cash balance plan. So a 50-year-old can get in substantially more than a 30-year-old. At the same time, their profit-sharing amounts are not indexed based on age.
For example, a 30-year-old can contribute approximately $73,000 to a cash balance plan, while a 50-year-old can contribute $200,000. At the same time, the profit-sharing cap for each person would be $46,500.
Is a Cash Balance or Defined Benefit Plan Right For You?
When you consider the fact that cash balance plan contributions are so much lower for a 30-year-old, they will receive significant leverage from the profit-sharing contributions while still being able to fund up to the 31% cap.
In addition, all things being equal, the preference is always to fund the profit-sharing as much as possible and limit the cash balance plan. This is because asset balances do not impact profit-sharing contributions.
Cash balance plan contributions include an interest credit typically ranging from 4 to 5%. Volatility will also cause swings in contributions. This is why the preference is always to fund the profit-sharing plan.
Comparing the 6% and 31% Rules: A Practical Example
Consider a 30-year-old sole proprietor who earns $1 million in net profit from their business in 2025. For plan purposes, the maximum deemed wage is $350,000. Under the 6% rule, the maximum profit-sharing contribution would be:
6% × $350,000 = $21,000
However, when applying the 31% rule, the combined allowable contribution—including defined benefit and defined contribution components—can reach up to 31% of the deemed wage.
31% × $350,000 = $108,500
The table below illustrates the contribution using the two different rules:
| 6% rule | 31% rule | |
|---|---|---|
| Profit-Sharing | $21,000 | $46,500 |
| Cash Balance | $73,000 | $62,000 |
| TOTAL | $94,000 | $108,500 |
This table clearly highlights the difference between the two strategies. For younger owners with high income and time on their side, the 31% rule can dramatically accelerate tax-deferred accumulation compared to traditional profit-sharing methods.
The larger contribution potential is particularly valuable because younger participants benefit more from long-term compounding. Over several decades, the additional tax-deferred growth generated by using the 31% structure can result in hundreds of thousands of dollars in additional retirement wealth.
Key Benefits of Using the 31% Rule for Younger People
- Allows for substantially larger contributions than the 6% profit-sharing approach.
- Maximizes long-term compounding for younger participants with decades until retirement.
- Creates greater flexibility in designing defined benefit plan funding levels.
- Reduces taxable income significantly for high-earning sole proprietors.
- Helps maintain compliance with IRS contribution limits while optimizing benefits.
- Coordinates seamlessly with the $350,000 deemed wage cap for 2025.
- Provides long-term retirement security while leveraging early-year savings growth.
These benefits highlight why many financial advisors and actuaries recommend the 31% framework for younger business owners who wish to maximize retirement plan efficiency.
Coordinating the 6% and 31% Rules for Optimal Results
While the 31% rule offers greater long-term potential, the 6% rule remains an important part of plan design. Combining both allows for optimal flexibility—especially when a business wants to fund both a defined benefit and a profit-sharing plan. By keeping the profit-sharing percentage at 6%, the plan leaves ample room for defined benefit funding under the 31% total contribution cap.
This combination ensures that the overall structure meets IRS testing standards while still maximizing deductible contributions. The profit-sharing component provides an element of liquidity and flexibility, while the defined benefit portion drives significant retirement accumulation. Together, they create a powerful strategy that works well for both tax planning and long-term financial stability.
Younger sole proprietors, in particular, can use this combination to front-load retirement savings during high-income years. With proper guidance from actuaries and financial planners, they can design a contribution strategy that adapts to changing income levels while maintaining compliance with all relevant tax rules.
Warning for S-Corp and C-Corp owners
You may be aware of the fact that S-Corps and C-Corps must issue a W-2 to report compensation. Contributions are not based on net income, but will solely use this W-2.
But when issuing a W-2, this structure will really work best when the W-2 is at least $350,000. Many business owners may issue a W-2 at a lower level to save on employment taxes. But if you do this, you’ll limit the 31% to this W-2 amount.
For example, if you earned $1 million a year but reported a W-2 income of only $100,000, then the 31% would be based on this number. Be very careful when considering the use of the 31% strategy for S Corp and C Corp owners.
Final Thoughts
For younger sole proprietors, the 31% rule represents a powerful opportunity to accelerate retirement savings and reduce taxable income. It capitalizes on both time and compound growth—two of the most valuable assets any investor can have.
Understanding the nuances between net income and deemed wage, as well as how both interact with IRS contribution limits, is essential for accurate planning. Business owners who take advantage of this strategy early in their careers can build substantial wealth while keeping more income sheltered from immediate taxation.
Ultimately, when designed and administered correctly, the 31% rule helps younger entrepreneurs transform high earnings into lasting financial independence. By aligning contributions with long-term growth potential and tax efficiency, it remains one of the most effective planning strategies available for ambitious, forward-thinking business owners.
