Traditional 401(k) profit sharing plans allow up to a 25% profit sharing contribution. What you may not have realized is that when you combine a cash balance plan or defined benefit plan, your 401k profit sharing contribution is limited to 6%. If you found out about this rule after you fully funded 25% into your 401k profit sharing, this was an unpleasant surprise.
So what can you do now? Is there anyway to correct this issue? In this post, we take a look through your options.
First, let’s take a step back. The IRS does not generally allow you to combine retirement plans. You can’t just add one retirement plan on top of another until you achieve your desired contribution.
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But the IRS does allow an exception. It actually allows a carve-out exception for 401k profit sharing plans and non-model SEPs of 6%. There is no limitation on the employee deferral because it is an elected employee contribution and not made by the employer.
So let’s take a look at a couple solutions:
- Error correction. The excess contribution may have been an honest error on your part. People make retirement contribution mistakes all the time. If that fits your situation, then you may want to consider an error correction. The IRS will allow certain corrections under the error correction program. You can find out a little more about the program here. How difficult is the process of self-correcting with your investment custodian? It depends. We have found that Fidelity, Vanguard, Schwab and Etrade all have different processes and different forms to be completed. But if you feel that you fall under the program, feel free to call your custodian and see if they can help you out.
- Mega Backdoor Roth. You have probably heard of the backdoor Roth, but have you heard of the Mega Backdoor Roth? Take a look at our article here. If you have a solo plan you may want to check your plan document to see if it allows after-tax contributions and in-service distributions. Assuming it does, you may be able to classify these excess contributions as after-tax.
- The 31% Rule. So you have heard here about the 6% rule, but were you aware of the 31% rule? This rule does not get that much attention, because in practice it doesn’t happen that much. The truth is that you have to meet the 6% rule or the 31% rule. The 31% rule simply restricts the cash balance plan or defined benefit plan to 31% of compensation. In most situations, you can get a contribution of 75% plus to a defined benefit plan. So restricting it to 31% just doesn’t make a lot of sense considering plan fees and administration. But in this situation, it might work great if you are looking to get a higher overall contribution.
So if you have overfunded your profit sharing plan, you have a few options.
