Many people know that 401(k) plans can be combined with cash balance plans and defined benefit plans. But when you combine them, there are IRS limitations relating to the 401(k) profit sharing contribution percentage. It goes from 25% down to 6%.
Questions always come up regarding how the 6% is calculated. If you have a W-2, you take gross compensation (subject to the annual limit) and apply it at the 6% rate. That’s pretty easy.
But since a sole proprietor does not issue a W-2, what is the deemed wage amount? Is it the business profit, or is it some other calculated amount? In fact, the deemed wage is something that we will need to back into to determine the proper funding level.
How do you calculate profit sharing for a sole proprietor? This article will walk you through the calculation.
Profit Sharing Calculation
The profit-sharing calculation for a sole proprietor is more challenging. In fact, it’s an algebraic equation that is certainly not simple for the average person to calculate.
At the end of the day, the business net profit must equal or exceed the sum of:
- 1/2 of self-employment tax;
- The cash balance plan or defined benefit plan contribution
- The 401(k) profit sharing contribution
- The “deemed” wage (as calculated by the TPA)
Said differently, the four components above cannot exceed net income. I will walk through an example and show you how it works.
Let’s assume we have a client with the following assumptions:
| Assumption | Variable |
|---|---|
| Plan year | 2025 |
| Age | 55 |
| Sole proprietor net income | $100,000 |
| Total self-employment tax (15.3%) | $14,130 |
| Defined benefit plan contribution | $50,000 |
What we need to do is calculate the deemed wage and then multiply that by 6% to calculate the profit-sharing calculation.
It is important to note, that the larger the contribution to the defined benefit plan, the lower the deemed wage and, as a result, results in a lower profit-sharing calculation.
Here is the calculation:
| Assumption | Variable |
|---|---|
| Sole proprietor net income | $100,000 |
| Half of self-employment tax | ($7,065) |
| Defined benefit plan contribution | ($50,000) |
| Deemed wage | ($40,505) |
| 401k profit sharing (6%) | ($2,430) |
| Variance | – |
Final Thoughts
Getting the math right between defined benefit contributions and 401(k) profit sharing is critical. For a sole proprietor, you must “back into” the deemed wage and cap profit sharing at 6 %. The larger your defined benefit contribution, the lower your deemed wage—and thus the smaller your allowable profit-sharing amount.
It’s easy to make miscalculations that leave you underfunded or noncompliant with IRS limits. That’s why working with a qualified TPA or actuary is essential in this blended plan setup. They help ensure you don’t exceed the income ceiling, misstate the deemed wage, or violate funding rules.
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