Frequently Asked Questions
Questions & Answers
What is a combination plan (a.k.a. DB-DC combo)?
This is an industry term to describe a creative plan design strategy where two plans, one a Defined Benefit Plan (DB), and the other a Defined Contribution (DC) plan (e.g., 401k, Profit Sharing, Money Purchase) are sponsored by the same Employer but combined for discrimination testing. This customized design approach often allows for significant contributions to owners or other select staff while maintaining reasonable costs for staff employees who are put in a DC plan (e.g., a 401k-Profit Sharing plan).
Why would an employer use a DB-DC combo plan approach?
In many cases, but not all, the Employer can generate higher contributions for a select group of employee (e.g., Owners and/or other select groups) by putting the select group in the DB plan and the remaining staff in the DC plan. The employer contributions to both plans are aggregated for discrimination testing which is performed not on current day contributions but rather tested at each participant’s projected retirement age by developing theoretical contributions and benefit accruals payable at retirement age. It involves some future value financial math and conversion to actuarial equivalent benefit accruals on the DC plan and utilizes an opportunity provided in some of the IRS regulations regarding discrimination.
Will this mean that rank-and-file employees are not required to be in the DB plan?
Sometimes it is still necessary to put some of the employees in the DB plan at very modest levels to satisfy Tax Code Section 401(a)(26) requirement that 40% of all eligible employees (those having met the age 21 and typical 1 year of service) have some meaningful benefit under the DB plan. The bulk of the staff contributions are typically made via the DC plan to pass most discrimination testing, so benefits a staff employee gets under a DB plan are usually very modest. In some small employer cases there may be enough owners and other select group members to satisfy the 40% participation requirement without including other staff. In this case all contributions to employees would be under the DC plan.
Where do we get the authority for utilizing an option to combine different plan types for discrimination testing?
The IRS has issued regulations on how the combined discrimination testing must be performed. The regulations are primarily found under Treasury Reg. 1.401(a)(4)-9. In addition, for an extra User Fee the IRS will review the dual-plan structure along with proposed contributions and benefits and issue a Favorable Determination Letter to the client.
What is the advantage of the DB-DC combo plan to staff employees?
The staff employees primarily understand and appreciate more the DC plan over the DB plan since the DC account balance approach is similar to their personal savings account format. Alternatively, the defined benefit accrued in a DB plan is generally expressed as an annuity payable at a future retirement age and is typically more difficult to understand and appreciate the benefits offered by the employer.
Can the DC plan in the combo arrangement still be a 401(k) Profit Sharing Plan with individually directed accounts?
Yes. The normal rules and options under a 401k-Profit Sharing plan will still apply so participants can still have individually directed investment accounts and use the excellent investment platforms that exist for 401k plans. Employers can still reduce their fiduciary liability exposure under ERISA 404 by providing investment education and allowing participants to self-direct their own funds in the DC plan. The DB plan must follow normal defined benefit plan rules and must be a pooled account with no individually directed accounts allowed.
Can the owner or other employees benefit in both plans simultaneously?
Yes. In 2000 an individual participant limit that previously combined and limited benefit accruals and contributions under differing plan types (Tax Code Section 415(e)) was repealed. Each plan still has it’s own respective individual participant limit under Tax Code 415(b) and 415(c), but the repeal of the overall combined limit now allows for higher combined accruals, although other factors such discrimination testing, and an overall 25% of total compensation tax deduction limit, can still curb contributions where there is a common participant(s) in both plans. Note that if there are no common participants in the plans then the combined plan 25% deduction limit does not apply (the profit sharing plan would still have an individual limit of 25% plus 401k deferrals).
Are there any other issues that tie both plans together in a DB-DC combo plan arrangement?
Yes. Part of the combined discrimination testing requires some uniformity in offering benefits, rights, and features to all participants under both plans. For example, loan availability, lump sum distribution options, life insurance benefits, and such things as a common retirement age would need to be offered on a non-discrimination basis under both plans. However, plan features unique to one plan type (e.g., self-directed accounts under a DC plan) do not have to also be offered under a DB plan since a DB plan by definition cannot have self-directed accounts.
Will a DB plan and a DC plan sponsored by the same employer have to be combined for discrimination testing?
No. It’s entirely possible for each plan to stand-alone for discrimination testing. However, sometimes the stand alone approach does not provide for the maximum benefits to owners and select employees under a DB plan unless you also have some owners and/or select employees who choose to benefit at the lower level DC plan. If the plans are not combined for discrimination testing then the benefits, rights, and features mentioned under Q&A #8 do not have to be offered on a non-discriminatory basis between the two plans.
Is the DB-DC combo structure sensitive to employee demographic changes?
It can be. Discrimination testing is heavily dependent on employee census data including employee ages, compensation, service, and benefit and contribution levels. Losing one or more employees from a certain group can in some situations upset the discrimination testing balance and cause the test to initially fail. The remedy is detailed under Treasury Reg. 1.401(a)(4)-11(g) through use of a “corrective amendment” to amend the plan retroactively to increase or bring another employee into a higher contribution group sufficient to pass discrimination testing. Fortunately this corrective amendment has a liberal adoption date and can be adopted as late as 9.5 months after the plan year, which is the date that all administration work typically has to be completed since that’s the due date of the plan’s tax filing (Form 5500).
Is there a minimum contribution level that all benefiting employees must receive in order to utilize the DB-DC combo approach?
Yes. In most cases if the DB-DC combo approach is used so that discrimination testing is being satisfied on a combined plan
basis, then there is a minimum “gateway” contribution for staff employees of 7.5% of pay. That is not to say that a
7.5% of pay contribution for staff will necessary satisfy ALL discrimination components, it could take even more
(e.g., 10% of pay) but the 7.5% is the required minimum to even use the DB-DC combo approach. There are some
alternative methods of satisfying the “gateway” requirement but often they are not practical and one of them requires
that staff benefit more under the DB plan than the DC plan, which is something usually the client is trying to avoid.
The bottom line is the DB-DC approach is a strategy best reserved for clients who wish to provide significant benefits to a select group (e.g., an owner group), as it’s going to cost a minimum of 7.5% of pay contribution for staff, possibly more, but it can often provide substantial contributions to the select group often in the $80,000 - $200,000 range annually depending on age and acceptable employee costs.