For sole proprietors using defined benefit plans, contribution percentages are governed by specific IRS rules. Two of the most common ones are the 6% rule and the 31% rule.
While the vast majority of plans will use the 6% rule, the 31% rule can work great for younger business owners looking to maximize contributions. Unfortunately, the 31% rule is often overlooked by advisors and administrators.
In this article, we will explain how these two rules work. We will discuss how to structure and test these plan design to maximize contributions. Let’s get started!
Some Background
One of the most popular plan designs is the combination of a 401(k) profit-sharing plan with a defined benefit plan. When two different plans are combined, the IRS may either prohibit the combination or limit the contribution amounts.
Fortunately, 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.
Specifically, the IRS permits 401(k) employee deferrals without any limitations because they classify these as “employee” contributions, not “employer” contributions.
When it comes to contributions for cash balance plans and profit-sharing plans, the IRS imposes two separate limits: a 6% limit and a 31% limit. These limits, while established, offer a framework that enables you to strategize your contributions effectively.
What is the 6% limit?
According to the IRS, when either a profit-sharing contribution or a cash balance contribution is capped at 6% of deemed compensation, the other contribution is not subject to any limitations, aside from specific standalone limits.
In simpler terms, if the profit-sharing contribution is set at 6% of the deemed wages, the cash balance plan can be funded up to the actuarial limit. This regulation applies to both types of contributions. Therefore, you can contribute 6% of your deemed compensation to the cash balance plan and still make additional contributions to the profit-sharing plan, up to the maximum allowable annual addition limit.
What is the 31% rule?
The 31% rule stipulates that the combined contributions from both the cash balance plan and the 401(k) profit-sharing plan cannot exceed 31% of the deemed compensation. You can allocate contributions between the two plans as long as the total does not surpass the 31% limit.
To ensure compliance with these two plans, the IRS requires that you meet either the 6% rule or the 31% rule. You do not need to satisfy both requirements; meeting just one of them is sufficient for the combination to be permitted (subject to other testing requirements).
When applied correctly, these guidelines can significantly enhance tax-deferred savings, particularly for self-employed individuals under the age of 40, who have a long time horizon to grow their retirement assets.
Why the 6% Profit-Sharing Limit Often Delivers the Maximum Deduction
At first, it might seem logical to raise the profit-sharing percentage to increase total savings. However, the mathematics behind defined benefit plan funding reveal a counterintuitive truth. Increasing the profit-sharing rate can actually reduce the maximum defined benefit contribution.
When actuaries calculate total allowable funding, higher profit-sharing allocations can limit the defined benefit portion. Keeping the profit-sharing percentage low—around 6% of deemed compensation—allows the defined benefit contribution to remain at its maximum. This strategy ensures compliance while optimizing the total deductible contribution.
Use EMPARION PLANS on
*Emparion is not affiliated with, endorsed by, or sponsored by these institutions.*
For most sole proprietors and professionals, this balanced structure—6% for profit sharing and the remainder for the defined benefit plan—produces the highest total retirement contribution under IRS rules. It is both tax-efficient and flexible for long-term planning.
Net Income vs. Deemed Wage: A Crucial Difference
Sole proprietors must understand how contributions are calculated, starting with the difference between net income and deemed wage. Net income is the business profit shown on Schedule C after deducting expenses. The deemed wage is an adjusted figure used by the IRS to determine plan contributions for self-employed individuals.
The deemed wage is generally lower than net income because it removes the impact of self-employment taxes and adjusts for plan contributions. This adjustment ensures parity with W-2 wages earned by corporate employees. For 2025, the maximum deemed wage that can be used in calculations is $350,000.
Even if a business earns $1 million in profit, only $350,000 counts toward retirement plan contribution limits. All contribution percentages, whether under the 6% or 31% rule, are applied to this capped deemed wage.
Practical Example: Comparing the 6% and 31% Rules
Let’s examine a 30-year-old sole proprietor who reports $1 million in net income in 2025. Because of the IRS compensation limit, the deemed wage is capped at $350,000. Using the 6% rule, the profit-sharing contribution would be:
6% × $350,000 = $21,000
Using the 31% rule, which combines both defined benefit and defined contribution components, the potential total contribution rises dramatically:
Is a Cash Balance or Defined Benefit Plan Right For You?
31% × $350,000 = $108,500
The following table illustrates the contribution under the two rules:
| 6% rule | 31% rule | |
|---|---|---|
| Profit-Sharing | $21,000 | $46,500 |
| Cash Balance | $73,000 | $62,000 |
| TOTAL | $94,000 | $108,500 |
This side-by-side comparison illustrates how dramatically the 31% strategy increases contribution potential—especially valuable for younger participants seeking long-term compound growth.
The result is clear—under the 31% rule, the business owner can contribute an additional $87,500 in 2025 alone. That larger contribution grows tax-deferred and compounds over time, giving younger owners a powerful head start in building retirement wealth.
Why the 31% Rule Favors Younger Sole Proprietors
The effectiveness of the 31% rule for younger business owners is largely due to how actuarial tables work. Generally speaking, the higher your compensation and the older you are, the more you can contribute to a cash balance plan. For instance, a 50-year-old can contribute significantly more than a 30-year-old. However, profit-sharing amounts are not adjusted based on age.
To illustrate, a 30-year-old can contribute approximately $73,000 to a cash balance plan, while a 50-year-old can contribute nearly $200,000. Meanwhile, the profit-sharing cap for both individuals is set at $46,500.
When considering that cash balance plan contributions are significantly lower for a 30-year-old, these individuals can benefit greatly from profit-sharing contributions while still having the ability to fund up to the 31% cap.
Additionally, it is generally preferable to maximize funding for the profit-sharing plan and limit contributions to the cash balance plan. This preference arises because asset balances do not affect contributions to a profit-sharing plan.
In contrast, cash balance plan contributions typically include an interest credit ranging from 4% to 5%. Furthermore, market volatility can lead to fluctuations in these contributions. For these reasons, it is always better to prioritize funding the profit-sharing plan.
Key Reasons the 31% Rule Works So Well
- Permits significantly higher total contributions than the 6% profit-sharing approach.
- Maximizes long-term compounding for younger participants with decades to invest.
- Offers flexible annual funding levels within IRS limits.
- Substantially reduces current-year taxable income for high earners.
- Aligns efficiently with the $350,000 deemed wage ceiling for 2025.
- Integrates smoothly with profit-sharing structures for additional planning options.
- Builds long-term financial security and retirement predictability.
These benefits demonstrate why the 31% rule is particularly advantageous for younger professionals who want to front-load retirement savings while incomes are strong.
Balancing the 6% and 31% Strategies
While the 31% rule drives long-term accumulation, the 6% rule remains essential to maximizing plan efficiency. Using both rules together allows a sole proprietor to fine-tune plan contributions for optimal results. The profit-sharing portion stays at 6%, leaving ample room for the defined benefit calculation to reach its full potential under the 31% cap.
This coordination ensures IRS compliance while still achieving the largest deductible contribution possible. It blends flexibility with structure—profit sharing provides liquidity, while the defined benefit plan delivers long-term wealth accumulation. When properly designed, the two complement each other seamlessly.
Younger business owners can benefit the most by using these rules in tandem, especially during their highest earning years. With expert actuarial and tax guidance, they can lock in the advantages of early, high-value contributions while maintaining flexibility and control.
Important Notice for S-Corp and C-Corp Owners
As an S-Corp or C-Corp owner, it’s essential to understand your obligations regarding compensation. Both types of corporations are required to issue a W-2 form to report employee compensation. However, retirement plan contributions are not determined by net income. They rely solely on the amount reported on the W-2.
For optimal benefit from this structure, the W-2 compensation should be at least $350,000. Some business owners may choose to issue a W-2 for a lower amount to reduce employment taxes. However, if you do this, your contribution calculations will be capped at that reported W-2 amount.
For example, if your annual earnings are $1 million but you report a W-2 of only $100,000, the contributions would be based on the $100,000 figure. It’s crucial to exercise caution when considering the 31% strategy for S-Corp and C-Corp owners, as it could significantly affect your final outcome.
Bottom Line
For younger sole proprietors, the 31% rule is one of the most effective tools for accelerating retirement savings and minimizing taxes. It allows larger contributions, faster compounding, and increased flexibility—all within IRS-approved limits. When compared to the traditional 6% profit-sharing rule, the long-term financial advantage becomes undeniable.
Understanding the difference between net income and deemed wage and how these figures affect contribution limits is crucial. By recognizing that the deemed wage is cap, business owners can structure their plans effectively and stay compliant while maximizing deductions.
With the right combination of defined benefit and profit-sharing contributions, younger entrepreneurs can convert today’s high earnings into lasting retirement wealth. The 31% rule offers a disciplined, strategic, and proven framework to achieve that goal.
