For business owners who combine a defined benefit plan with a 401(k), the IRS imposes specific rules that govern how much they can contribute to each plan.
Two important rules to understand are the 6% rule and the 31% rule. These rules help ensure compliance with IRS regulations while allowing business owners to optimize their retirement contributions.
In this article, we’ll explore both rules in detail and provide examples of how they work in practice.
This post highlights some of the discussion that occurred on our podcast. The 6% rule and the 31% rule come up often. So the discussion was very timely. Take a look at the podcast on our YouTube video below:
Overview of Profit Sharing in 401(k) Plans
A 401(k) plan allows both employee deferrals and employer contributions. As a business owner, you can contribute to your employees’ or your own retirement through profit sharing. Under typical circumstances, profit sharing contributions are capped at 25% of the W-2 income, allowing substantial retirement savings.
However, when you combine a 401(k) with a defined benefit plan, things get a little more complex. The IRS limits how much you can contribute to each plan to prevent excessive tax deferral. This is where the 6% rule and the 31% rule come into play.
The 6% Rule: Profit Sharing Limits with DB Plans
The 6% rule applies when you have both a 401(k) and a defined benefit plan in place. Normally, your 401(k)profit-sharing contribution can go up to 25% of your W-2 compensation. However, once you add a DB plan, the IRS limits that profit sharing contribution to 6% of your compensation.
Example: 6% Rule in Action
Let’s say you’re a business owner with a W-2 income of $100,000. Without a DB plan, you could contribute up to 25% of that amount, or $25,000, in profit sharing. But if you have a defined benefit plan, the 6% rule applies, meaning your profit sharing contribution is now limited to $6,000.
While this reduces the profit-sharing contribution, the trade-off is that you can make significantly larger contributions to your DB plan. The DB plan contribution often far outweighs what you lose on the 401(k) profit sharing side.
Why the 6% Rule Exists
The 6% rule exists to prevent excessive tax deferral through profit sharing contributions when combined with a DB plan. The IRS imposes this limit to balance contributions across plans while allowing business owners to still take advantage of the high contribution limits available in DB plans.
Introduction to the 31% Rule
The 31% rule offers another option for businesses with both a DB plan and a 401(k). This rule states that the combined contributions to both plans cannot exceed 31% of your compensation. This gives you the flexibility to contribute more to your profit sharing in certain situations, as long as the combined total of profit sharing and DB plan contributions doesn’t exceed 31%.
Let’s take the same example: A business owner with a $100,000 W-2 income. Under the 31% rule, you could contribute up to 25% of your W-2 income, or $25,000, to your 401(k) profit sharing, plus an additional 6% into your DB plan (in this case, $6,000). This would bring your total contributions to $31,000, or 31% of your income, which keeps you within IRS limits.
When to Use the 31% Rule
While the 31% rule offers more flexibility, it’s not always the best option. In most cases, the goal of having a DB plan is to make larger contributions than what the 401(k) allows. Using the 31% rule could limit your DB plan contributions to a small amount, making the plan less effective.
However, the 31% rule can be beneficial in specific situations, such as:
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- Overfunded DB Plans: If your DB plan is overfunded, and you need to reduce contributions to the DB plan, using the 31% rule can help shift more contributions into the 401(k) profit sharing.
- Down Years: In years when your income is down or when you’ve already contributed significantly to your DB plan in previous years, the 31% rule allows you to maintain contributions through your 401(k) while reducing the DB contribution.
Overfunded DB Plans: Using the 31% Rule for Correction
One of the primary uses of the 31% rule is when a business owner’s defined benefit plan becomes overfunded. This happens when the contributions exceed what is required to meet the future payout obligations. In this case, reducing the DB contributions and shifting funds to the 401(k) profit-sharing plan (within the 31% limit) can help bring the plan’s funding back in line without significantly reducing your overall retirement savings.
Similarly, if you have a down year in income, the 31% rule allows you to maintain flexibility, contributing more to profit sharing and less to the DB plan temporarily, while keeping your overall retirement savings intact.
Common Misconceptions about the 31% Rule
Many business owners assume that the 31% rule is a long-term solution for managing retirement contributions, but that’s not the case. It is typically used in specific scenarios, such as correcting overfunded plans or managing contributions during low-income years.
Additionally, the costs of maintaining a DB plan are significant, and using the 31% rule to contribute only small amounts to the DB plan may not be worth the administrative burden in the long run.
Best Practices for Balancing 401(k) and DB Contributions
When it comes to balancing contributions between your DB plan and your 401(k), here are a few best practices to keep in mind:
- Understand the 6% and 31% Rules: Knowing when to apply each rule can help you optimize contributions without running afoul of IRS guidelines.
- Maximize DB Plan Contributions First: In most cases, your DB plan will offer the largest contribution potential, so it’s typically best to focus on funding that plan first.
- Use the 31% Rule Sparingly: This rule is best used as a temporary solution, such as when your DB plan is overfunded or you need to adjust for a down year.
- Consult a Professional: The rules around DB plans and 401(k)s are complex, so it’s always wise to consult with a financial professional or TPA to ensure compliance.
Bottom Line
The 6% rule and the 31% rule are two key IRS guidelines that business owners need to understand when combining a defined benefit plan with a 401(k). By balancing your contributions strategically, you can maximize your retirement savings, minimize your tax liability, and stay within compliance. However, these rules are not always intuitive and using them effectively often requires professional guidance.
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