Many business owners already have a retirement plan like a 401(k), SIMPLE IRA, or SEP in place when they start exploring the idea of adding a defined benefit plan.
While combining plans can lead to increased tax deferral and retirement savings, there are specific IRS rules to follow, and not all plans can be combined. This article explores how to effectively combine a DB plan with other retirement plans and the pitfalls to avoid.
Plan design is a critical step in the process. If you’re looking to combine multiple plans, then you’ll need to be really careful with compliance.
This article will discuss items covered on our podcast. It was a very spirited discussion that covered a lot of details pertaining to other plans. Take a look at the video of the podcast below on our YouTube channel:
Overview of Retirement Plan Types
Before diving into how to combine plans, it’s essential to understand the basics of each type:
- Defined Benefit (DB) Plan: A retirement plan where contributions are based on a guaranteed future benefit. The amount you can contribute is typically higher than with defined contribution plans, making DB plans attractive for high-income earners.
- 401(k) Plan: A defined contribution plan that allows employees (or business owners in the case of solo 401(k)s) to make pre-tax or Roth contributions. Employers can also offer profit-sharing contributions.
- SIMPLE IRA: A retirement plan designed for small businesses with fewer than 100 employees. It has lower contribution limits than 401(k)s or SEPs and comes with fewer administrative requirements.
- SEP (Simplified Employee Pension): A retirement plan where only employers contribute. It’s easy to set up and has higher contribution limits than SIMPLE plans, but its rules vary depending on whether it’s a model SEP or a non-model SEP.
IRS Rules for Combining Retirement Plans
The IRS imposes strict rules on combining different retirement plans. Some plans can be paired effectively, while others are either prohibited or limited in terms of total contributions. The key factors to consider are:
- Contribution Limits: The IRS caps total contributions for individuals across all plans. Exceeding these limits can result in penalties.
- Plan Compatibility: Certain retirement plans, like SIMPLE IRAs, cannot be combined with other qualified plans, while others, like 401(k)s, are more flexible.
Combining a Defined Benefit Plan with a 401(k)
A 401(k) plan is the most compatible option to pair with a DB plan. This combination provides business owners with the ability to maximize their retirement savings by leveraging both plans’ tax advantages.
- Deferrals: In a 401(k), you can defer up to $23,500 ($31,000 if you’re over 50), reducing your taxable income.
- Profit Sharing: Employers can also contribute through profit-sharing, which adds flexibility. When combined with a DB plan, you can balance high annual contributions with the flexibility of a 401(k).
For example, if your DB plan requires you to contribute $100,000 in a given year, adding a 401(k) allows you to increase your retirement savings with elective deferrals and profit-sharing, possibly pushing your total contributions to $130,000 or more.
Challenges of Combining a Defined Benefit Plan with a SIMPLE
A SIMPLE IRA has significant limitations when it comes to combining with other retirement plans. The IRS does not allow SIMPLE plans to be paired with other qualified plans like DB plans, meaning that if you have a SIMPLE in place, you cannot add a DB plan.
- SIMPLE Plans Are Restrictive: While SIMPLE plans are easy to administer, they have lower contribution limits and can’t be combined with other plans like 401(k)s or DB plans. This makes them less ideal for high-income earners or growing businesses.
- Best for Small, Stable Incomes: SIMPLE IRAs can make sense for businesses with moderate income and a small number of employees, but they’re not the best option for those looking to maximize retirement savings or for businesses expecting significant growth.
Combining a Defined Benefit Plan with a SEP
SEPs are another common retirement plan used by small businesses, but not all SEPs are compatible with DB plans. The IRS distinguishes between model SEPs and non-model SEPs.
- Model SEP: The IRS specifically prohibits combining a model SEP with other qualified plans like DB plans.
- Non-Model SEP: A non-model SEP, which is more customizable, may allow for a DB plan combination, though contributions must adhere to IRS limits (usually capped at 6% for profit sharing). If you have a non-model SEP, this can work alongside a DB plan, but it’s essential to ensure you’re not exceeding contribution limits across both plans.
Special Considerations for Business Owners with Multiple Plans
If you’re a business owner with multiple businesses, you may assume that you can have separate retirement plans for each company. However, the IRS control group rules treat all your businesses as a single entity when it comes to retirement planning. This means that retirement plans across all businesses must comply with IRS contribution limits as if they were a single plan.
- Control Group Rules: If you own multiple businesses, even if they are legally separate entities, they may be treated as a single plan for retirement purposes. All employees across those businesses must be included in the same retirement plan, preventing you from setting up a DB plan in one company and a SEP or 401(k) in another to maximize contributions.
Real-Life Scenario: Multiple Businesses and Retirement Plans
Consider a business owner with three companies. They have a SEP in one company and want to set up a DB plan in another for themselves and their spouse. According to IRS rules, because they have a controlling interest in all three companies, they must treat the retirement plans as if they are under one plan. This means they cannot maintain separate SEP and DB plans to maximize contributions.
In another scenario, if the business owner works for a friend’s company and receives retirement benefits from that unrelated business, it does not affect their ability to set up a DB plan for their own business. This is allowed as long as they don’t control the company where they are receiving the additional retirement benefits.
Maximizing Contributions When Combining Plans
Combining a DB plan with a 401(k) allows for maximum flexibility and higher contribution levels. You can contribute significant amounts to your DB plan while also taking advantage of the deferrals and profit-sharing options in your 401(k). This strategy allows you to optimize tax deferral and retirement savings over time.
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Business owners often make the mistake of assuming they can max out contributions across all retirement plans. However, the IRS imposes strict limits, and combining plans without considering these limits can lead to penalties. Additionally, many business owners mistakenly believe that owning multiple businesses allows them to set up separate plans for each, but control group rules prevent this.
Final Thoughts
When combining a defined benefit plan with a 401(k), SEP, or SIMPLE, it’s crucial to understand IRS rules and plan compatibility. 401(k)s pair well with DB plans, providing flexibility and higher contribution limits, while SIMPLE and model SEP plans come with more restrictions. Business owners with multiple entities need to be aware of control group rules that may impact how they structure their retirement plans.
Consulting with a professional before making decisions about combining plans is essential to avoid penalties and ensure you’re maximizing your retirement savings.
