The Advantages of “Combo Tested” Defined Benefit and Defined Contribution Plans
In the qualified plan realm, sometimes a Defined Contribution Plan (DC) such as a Profit Sharing Plan is an ideal design for a small office. Consider the following example for a 2017 Plan Year:
For a 2017 Plan Year, the maximum contribution for any employee is $54,000 or 100% of the employee’s salary, whichever is less, and the maximum salary that can be taken into account for any employee is $270,000. Total plan contributions cannot exceed 25% of the total salaries of the participants.
Owners and their spouses, as well as employees with compensation in excess of $120,000 in the prior year, are considered “Highly Compensated Employees” (HCE). All other employees are “Non-Highly Compensated Employees” (NHCE). When the Allocation Rates are not uniform, special nondiscrimination testing must be passed between the HCEs and the NHCEs. NHCE’s must receive at least a 5% allocation rate on employer contributions (or, if less, 1/3 of the highest rate allocated to any HCE). In this case, the allocation rate for NHCE 3 had to be raised to 13.100% to pass the nondiscrimination testing.
The addition of a 401(k) feature to the plan, where each employee can make contributions out of his or her salary up to a maximum of $18,000 in 2017, with an additional “catch up” contribution of up to $6,000 for employees over the age of 50, can be even more attractive. The “catch up” contribution does not count toward the $54,000 limit on contributions. Making a fully vested “safe harbor” contribution to each eligible employee equal to 3% of salary allows HCEs to maximize their 401(k) contributions without having to pass special nondiscrimination testing on those contributions. Lowering the employer contributions to the Owner & spouse requires giving only 11.375% in employer contributions to NHCE 3 while still passing the nondiscrimination testing:
Now suppose the company has substantial earnings above the maximum amount that can be contributed to a Defined Contribution Plan on which they want to defer current taxation. One possible solution would be to add a Defined Benefit Pension Plan (DB). In such a plan, the maximum monthly benefit payable at ages 62-65 that can be accrued in the 2017 Plan Year is $1,791.67. Based on the $270,000 maximum salary that can be taken into account ($22,500 monthly), this translates into a benefit formula of 7.965% of compensation to be accrued by each participant. An actuary calculates and certifies the amount of the employer contribution needed to fund this accrued benefit for each participant. If this is a professional company, the maximum employer contributions to the 401(k) Profit Sharing Plan are limited to 6% of the total participant salaries. This design allocates only the 3% safe harbor contribution to the NHCEs. The Owner and wife receive the 3% safe harbor contribution plus 4.22034% in Profit Sharing contributions. Adding the DB Plan to the mix produces these results:
Here’s where the advantage of “combo testing” becomes evident. If the Plan Years of the two plans are the same, the regulations allow the employer contributions to the 401(k) Profit Sharing Plan to be converted into an equivalent monthly benefit that would be provided under the DB Plan which, when added to the monthly benefit provided under the DB Plan, shows that the combined benefits are nondiscriminatory. The reason this can work so well is that the actuary can assume a future rate of return of up to 8.50% per year on the employer contributions to the 401(k) Profit Sharing Plan, from the current year until each participant’s anticipated year of retirement. By comparison, the regulations require the use of much lower interest rates to be used in the funding of the DB Plan. By lowering the monthly benefits accrued by the NHCEs in the DB Plan (to the minimum “meaningful” 0.50% of salary) while increasing their employer contributions to the 401(k) Profit Sharing Plan, the savings achieved in the DB Plan exceed the added costs in the 401(k) Profit Sharing Plan. The total employer contributions to the 401(k) Profit Sharing Plan are still limited to 6% of the total participants’ salaries. For combo discrimination testing, the minimum employer contribution to the 401(K) Profit Sharing Plan for the NHCEs is 7.50% of salary:
This combo testing design can also work for larger companies because the employees covered by the DB plan and the employer contributions to a DC plan can be limited to just 40% of the otherwise eligible group of employees, provided that coverage percentage of the NHCEs is at least 70% of the coverage percentage of the HCEs.