By now you are probably aware of the advantages of defined benefit plans. They offer high tax deferred contributions that are not possible with defined contribution plans, like 401ks. But what if you want to make larger tax deductible contributions?
Can you combine a defined benefit plan and a 401k plan?
The simple answer is yes. But there is a catch. The contributions to the 401k profit sharing portion will be limited.
In this post, we will show you how it works and teach you the rules. That way you can stay compliant and maximize your contributions.
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So how does it work?
The good news is that you can have both plans at the same time. But the IRS places restrictions and limitations when combining the plans together.
So here are the rules. There is actually no restriction on the employee 401k deferral. This allows a contribution of $19,500 for employees under the age of 50 and $26,000 for those 50 and older.
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The reason is that this is a “deferral” that was elected by the employee. It is not a company contribution like a defined benefit plan. The defined benefit plan is actually a company sponsored plan. The employee is not allowed to contribute separately.
However, the profit sharing contribution of a 401k plan is company sponsored. What this means is that it is contributed at the discretion of the company (safe harbor rules aside).
The 6% limitation
So most 401k plans allow a profit sharing contribution as high as 25% of compensation. But when you combine the two plans together, the profit sharing contribution is limited to 6% of compensation.
The 6% limitation rule is “disappointing” to many business owners looking to combine both plans. But I must remind them that they were able to get significantly more contributions made with a combined plan compared to a standalone defined benefit plan. Let’s look at an example below:
Let’s assume Amy is a 55 year old physician with an S-Corp structure. She earns $400,000 annually. Let’s also assume she pays herself a wage of $200,000. With just a 401k plan she would be able to make the following contribution:
| Contribution Type | Amount |
|---|---|
| 401k Employee Deferral | $26,000 |
| 401k Profit Sharing | $37,500 |
| Defined Benefit Plan | $0 |
| Total Contribution | $63,500 |
Because she is over age 50, she is allowed the 401k employee deferral of $26,000, which is the maximum allowed. She is also entitled to the maximum profit sharing amount. This will get her to the maximum annual cap for 2020 of $63,500. But of course – no defined benefit contribution.
The Defined Benefit 401k Combo Plan
So let’s now assume that Amy sets up a defined benefit plan and combines it with a 401k (some call it a “combo” plan). The numbers below look a lot better. This of course assumes she is looking for the largest tax deductible contribution possible.
| Contribution Type | Amount |
|---|---|
| 401k Employee Deferral | $26,000 |
| 401k Profit Sharing | $12,000 |
| Defined Benefit Plan | $170,000 |
| Total Contribution | $208,000 |
This situation looks a little better for Amy! You will see no change in the employee deferral, but a steep decrease in profit sharing contribution. Remember in the original example, Amy was able to contribute the maximum allowed to her 401k plan.
But in this example she is limited to a profit sharing contribution of just $12,000, a decrease of $25,500. That’s a big drop. This amount is calculated by multiplying the 6% times her W2 of $200,000. Her business profit or pass through income does not apply to the profit sharing calculation.
But take a look at the defined benefit plan contribution. It is $170,000 and could even be a little higher based on prior service or front loading the contribution. But you get the overall picture. When doing a combo plan, she is able to get over 3 times the total contribution!
Why add a 401k plan to a defined benefit plan?
With such large contributions available to you under a defined benefit plan, why would someone even need to set up both plans? Does it really help much considering the fees associated with testing both plans annually?
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This is certainly a good point. But probably 90% of the plans we set up are combo plans. This is for the following reasons:
- Many businesses with defined benefit plans have combined federal and state tax rates that range from 40% to 50%. With tax brackets this high, every extra dollar contributed yields sizable benefits.
- 401k plans are elective. So if the owner is having a down year financially they can choose to not make the 401k employee deferral or profit sharing contribution. This gives them added flexibility. If the employer has other employees then they may be required to make small safe harbor contributions. But I think you get the point.
- The 401k plan has lower cost and testing requirements compared to the defined benefit plan. So once you have the “DB Plan” in place the cost associated with the 401k is minimal. But make sure you discuss the cost with your third party administrator.
Tips when combining plans
As you can see, you can combine a defined benefit plan with a 401k plan. This is done all the time by many different administrators and financial advisors.
But don’t forget the 6% limitation on the 401k plan. Make sure you discuss all the issues of a combo plan with your TPA. Their job is to guide you every step of the way.
How to combine a 401k with a defined benefit plan
- Run an illustration with a combo plan. Your administrator is tasked with providing an illustration of what a combo plan might look like in your financial situation.
- Beware of the limitations and restrictions. Your administrator should hold your hand through the plan structuring to make sure that all rules are followed.
- Consult your financial advisor. Your riskier assets should be in the 401k plan and the defined benefit plan would have more conservative investments. Your financial planner should be well versed on these issues.
- Consider the added cost. As discussed, the added cost is minimal considering the flexibility of having two plans. But it should at least be considered and addressed up front.
- Mega Backdoor Roth. If this is a solo plan, make sure to consider combining with a Mega Backdoor Roth. This can be the best of both worlds.
