Cash Balance and Safe Harbor 401(k) Combo for a Dental Practice
Ridgeway Orthodontics is a professional corporation with three owner-dentists and 14 staff. The owners, ages 62, 58, and 55, each earn $310,000. Staff earn between $38,000 and $72,000, with average compensation of $52,000. The practice sponsors a 401(k) safe harbor nonelective plan with a 3% of pay contribution and wants to add a cash balance plan with pay credits of 9% for owners and 3% for staff. The owners want to contribute the maximum deductible amount while keeping staff costs low. The combined plan would cover all 17 employees. The actuary projects a first-year cash balance contribution of $420,000 for owners and $43,000 for staff and notes the plan will be top-heavy. The 401(k) has a 12-month waiting period and a last-day/1,000-hour allocation requirement. The owners ask whether the design will pass nondiscrimination testing and whether the staff contribution can be reduced.
1. Will the combined cash balance and 401(k) design satisfy coverage, minimum participation, and nondiscrimination rules? Identify the tests and the pressure points.
Read the worked answer
The practice is one employer for plan testing. Coverage under IRC 410(b) is likely satisfied because the combined plans cover all 17 employees, although the 12-month eligibility rule can exclude new hires and must be monitored annually. The cash balance plan must satisfy IRC 401(a)(26): it must benefit the lesser of 50 employees or the greater of 40% of all employees or two employees. Forty percent of 17 is 6.8, rounded up to 7, so the plan passes if at least 7 employees benefit. A last-day/1,000-hour condition can reduce the benefiting count, so the actuary should confirm the count each year.
The harder test is IRC 401(a)(4). The DB and DC plans can be aggregated and tested on a benefits basis under Treas. Reg. 1.401(a)(4)-8 and -9, but the gateway must be met: each NHCE needs an aggregate normal allocation rate of at least 5% of compensation, or one-third of the highest HCE rate if that is lower. The 3% safe harbor plus the 3% cash balance pay credit does not automatically equal a 6% allocation rate. The cash balance accrual must be converted to an equivalent allocation rate using standard interest and mortality assumptions. For younger staff, a 3% pay credit may produce a lower equivalent rate, and the plan may fail the gateway. The top-heavy minimum under IRC 416 also applies; a 3% DC contribution alone may not satisfy the 5% DC minimum or the DB minimum benefit. The design is not safe without cross-testing.
2. Can the owners reduce the staff cash balance credit to 2% or 1% and still pass testing? What alternatives would you recommend?
Read the worked answer
Reducing the staff credit to 2% or 1% would make the gateway and top-heavy problems worse. The gateway is measured on the aggregate normal allocation rate, not on the pay credit alone, so a lower cash balance credit pushes NHCEs further below 5%. The plan would likely fail IRC 401(a)(4) and could also fail the top-heavy minimum. A 1% credit would also raise questions about whether the staff are meaningfully benefiting under the cash balance plan for IRC 401(a)(26), especially if last-day/1,000-hour conditions exclude some employees.
Better alternatives include: increase the 401(k) safe harbor nonelective to 5% and keep a modest cash balance credit; increase the staff cash balance credit to a level that produces at least a 5% aggregate allocation rate after conversion; move staff to a DC-only allocation with a 5% gateway contribution while limiting the DB plan to owners and a small number of staff who satisfy 401(a)(26); or reduce owner pay credits so the highest HCE rate falls and the one-third gateway is easier to satisfy. Each alternative should be tested with the actual ages, compensation, and actuarial assumptions. The owners should also consider the IRC 404(a)(7) combined deduction limit, although DC contributions up to 6% of compensation are generally disregarded for that limit.
3. What are the deduction and top-heavy implications of funding $420,000 for owners and $43,000 for staff?
Read the worked answer
The cash balance contribution is deductible under IRC 404(o), subject to the funding target, target normal cost, and cushion amount. The 3% safe harbor nonelective is deductible under IRC 404(a)(3) or 404(a)(7). Because the DC contribution is 3% of compensation, it is within the 6% of compensation disregarded for the IRC 404(a)(7) combined DB/DC limit, so the combined limit should not cut the DB deduction. The actuary should still confirm that the $420,000 owner contribution does not exceed the 404(o) maximum, especially if the plan has a surplus or credit balance.
For top-heavy, the combined plans are a top-heavy group if more than 60% of account balances and accrued benefits belong to key employees. The plan must provide the IRC 416 minimum to non-key employees. In a DB/DC combo, the minimum can be satisfied in the DB plan with 2% of average compensation per year of service, up to 20%, or in the DC plan with 5% of compensation. The 3% safe harbor alone does not satisfy the 5% DC minimum. If the cash balance credit is only 3%, the actuary must test whether the DB accrual plus the DC contribution satisfies the top-heavy minimum. If not, an additional contribution is required, which increases the staff cost the owners were trying to control.