Are Cash Balance Plan Fees Worth It?

I’m a big fan of Getting P.A.I.D. – converting a high hourly rate of active income into multiple streams of passive income.  One of the ways you can really boost your savings is to take advantage of self-employed retirement accounts like a Solo 401(k) and a cash balance plan.

The Solo 401(k) is a no brainer – it’s cheap to administer, there are lots of low-cost investing options and you can calculate the contributions yourself.  The decision to participate in a cash balance plan is more complicated.  While the plan may save you thousands of dollars in taxes, there are significant costs to establishing, maintaining and terminating the plan.  All those costs can eat away at your savings, which begs the question – are cash balance plan fees worth it?

title photo

The Set Up

Let’s compare 2 scenarios.  A physician with significant side income as an independent contractor or owner of an S-corp is deciding between investing $50,000/year in a cash balance plan VS paying taxes on that $50,000 and invest the remainder in a taxable account.  The doctor’s marginal federal tax rate is 35% and state tax rate is 7%.  After paying taxes she has $29,000 remaining to invest.

After 5 years she decides that she no longer wants to keep working her current pace.  She stops her side hustle and rolls over her cash balance plan into a 401(k).  In the alternative scenario she keeps her funds in her taxable account but doesn’t add any new contributions.  From this point forward she invests in the same low-cost index fund in both scenarios.

The Fees

Losing more than 40% of your side income in taxes sounds pretty painful, but paying high investment costs is no picnic either.  One of the most affordable cash balance plans that an independent contractor could use is the Schwab Personal Defined Benefit Plan.

The plan costs $1,500 to establish.  It costs another $1,500 in annual maintenance and actuarial fees.  When you want to terminate the plan it will cost you a whopping $4,500 to close the account.  As a cheap Boglehead who firmly believes that fees are the destroyer of returns, paying these kind of fees seems sacrilegious.  But are the fees worth saving tens of thousands of dollars a year in taxes?  Let’s find out.

The Contribution Years

The cash balance plan costs $3,000 in year one ($1,500 to set up and $1,500 in annual fees) and $1,500 each additional year.  It has to be invested more conservatively, so it targets 5% growth.

The taxable account invests in a total stock market index fund and averages 8% growth.

contribution years

Despite the high fees and lower returns, the cash balance plan balance is worth $266,170, while the taxable account is worth $170,132.

Set It and Forget It

After 5 years Dr. Hustle decides it’s time to cut back.  She gives up her side job and can no longer contribute to a cash balance plan.  She pays the whopping $4,500 termination fee and rolls it over into her 401(k).  She then invests this lump sum in the same index fund she would have bought in a taxable account.  She never needed this extra cash in the first place, so she watches it grow undisturbed for years.

Unlike the taxable account that she could tap at any time, this tax-deferred money is trapped in a retirement account.  She has to play by the IRS rules.  She can access the money penalty free at age 59 1/2, and is required to start taking minimum distributions at age 70 1/2.

grow til 60

By age 60 the tax-deferred account is worth $896,465 while the taxable account is worth $582,862.  That’s an extra $313,603 in retirement savings!

End of the Road

It was a good run while it lasted, but after age 70 the IRS is going to make Dr. Hustle start withdrawing the money whether she needs it or not.  Let’s see what the final tally is.

grow til 70

By age 70 the cash balance plan ballooned to $1,935,402.  The taxable account grew to a respectable $1,258,355.  The final difference between the two scenarios is $677,047.

Are the Fees Worth It?

As much I hate the thought of paying high investing fees, I have to admit that the costs of a cash balance plan are worth doubling your tax deferred investing space.  Even if you only contribute for 5 years, those extra savings will grow much faster compared to a taxable account.

There is a 600 pound gorilla in the room that we haven’t discussed.  Uncle Sam may be patient, but eventually he wants his cut.  Deferring taxes is different than avoiding taxes. If future tax rates are significantly higher than present (which is a good possibility), those taxes could negate the extra savings.

The other risk for a hard-working super-saver is that they end up saving too much in tax deferred accounts.  If you’re the kind of person who side hustles and invests the earnings in a cash balance plan, you’re probably also the kind of person who has been maxing out a 401(k), profit-sharing plan or solo 401(k).  When those RMDs are due you may discover that decades of diligent saving has actually pushed you into a higher tax bracket in retirement than you were during your peak earning years.

Your best bet is to have some combination of pre-tax (401k), tax-free (Roth, HSA) and taxable accounts during retirement.  This gives you maximum control over your tax rate.

If you have significant side income and have already maxed out your other retirement accounts, a cash balance plan may be the solution for you. The fees may sound scary, but the substantial tax savings are hard to beat.

What do you think?  Do you think cash balance plan fees are worth the tax deferral?  Do you think the tax tail is wagging the dog?  Share your thoughts and comments below.  

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2 thoughts on “Are Cash Balance Plan Fees Worth It?

  1. SHS,

    Not that it will surprise you (thanks to humor mind-meld, when you break your arm mine hurts) but I came to the same conclusion, and I use a cash balance account. There are less costly actuary firms that provide the service – try asking the older, financially savvy docs who they use and inquire on the costs. In my case, fees run closer to $1k a year.

    A cash balance plan is a tool for physicians with the income and discipline to save aggressively beyond the $56k combined limit in 2019. If you have the money to save and want to reduce your tax burden now, it’s a great if pricey extra arrow in your quiver. While intended as a pension (hence the “defined benefit”) you rightly point out that it can be rolled over to a 401k when you leave the employer. The catch is it needs to stay open long enough to avoid scrutiny from Uncle Sam that this was your plan all along. My actuary suggests you keep this baby open for 5-7 years to avoid audit – a long time to pay high recurring fees.

    As for tax treatment, I wouldn’t let the tax tail wag the dog on this one (per WCI). You can roll cash balance plan savings over to a 401k when you terminate your relationship with the employer, and then proceed to perform strategic Roth conversions from the 401k so that you optimize the amount you keep and legally reduce the amount Uncle Sam gets. Gasem is the king of this space, having planned out a Roth conversion schedule that will significantly transfer his nest egg from tax-deferred to tax free while optimizing tax treatment:

    If you have other uses for that money (home downpayment, etc) or if you cannot afford to contribute significant amounts on a regular basis, just go the route of taxable and keep life (and accounting) simple.

    In the end, every bit helps. As Bernstein likes to say, the goal is not to die rich; it’s to NOT die poor.

    Enjoyed your head to head comparison.




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