How a Cash Balance Plan can Wreck Your Solo 401(k)
What your CPA might've forgotten to warn you about
Did your CPA tell you to start a Cash Balance Plan STAT so you can shelter six figures of income from taxes annually?
Sounds amazing, right?
But before you dial 1-800-CASH-BALANCE-PLAN, make sure your tax guy mentioned this:
Adding a Cash Balance Plan to your existing Solo 401(k) can wipe out your ability to max out the Solo 401(k) in pre-tax dollars.
If they forgot to mention that…
Let me show you what that plays out in real life.
Meet Dr. Harvard
Dr. Harvard is a hustler.
He works locums hard for 6 months, then vanishes to Costa Rica for the other 6. Work hard, play hard.
Here’s his setup:
Age: 49
Filing status: Single
Entity: Sole Proprietor
Net profit (Schedule C): $350,000
Employees: None
Each year, Dr. Harvard maxes out his Solo 401(k):
$23,000 elective deferral (as the “employee” of his business)
$47,000 employer contribution (as the “employer”)
He decides to set up a Cash Balance Plan (a type of defined benefit (DB) plan), so he hires an actuary to run the numbers.
The verdict?
To retire at age 65 with the maximum lifetime benefit under a cash balance plan (about $3.5M), he needs to contribute at least $125,000 per year.
Sounds fantastic, right?
That $125,000 is a tax-deductible business expense - which means his taxable income drops by $125,000.
An amazing, legal tax shelter…
Or is it?
The Surprise: Dr. Harvard’s $47,000 Solo 401(k) Employer Contribution Gets Crushed
Dr. Harvard was celebrating - popping bottles in the ice and riding high - until reality hit.
Once he started the Cash Balance Plan, he found out he can’t deduct both his full Solo 401(k) employer contribution and the $125,000 cash balance contribution.
Wait - what!?
Blame IRC §404(a)(7) – a sneaky tax rule that limits how much a sole proprietor can deduct across both a defined contribution plan (like a Solo 401(k)) and a defined benefit plan (like a cash balance plan)
The Rule: 25% Combined Deduction Cap
According to the IRS, when you have both a defined contribution plan (DC) and a defined benefit plan (DB), your combined employer contributions are generally capped at 25% of your net earnings from self-employment.
In Dr. Harvard’s case
Net SE income (after SE tax deduction): $325,248
25% × $325,248 = $81,312
But he’s trying to contribute:
$125,000 to the Cash Balance Plan
$47,000 to the Solo 401(k) as employer contribution
Total: $172,000 ← way over the $81,312 limit
Important Note: Technically, you can contribute more than 25%, but any amount above that limit is not deductible in the current year. It must be carried forward and possibly deducted in a future year… if there’s room.
Does That Mean He Has to Lower His Cash Balance Plan Contribution?
Thankfully, no.
There are two important exceptions under IRC §404(a)(7) that allow Dr. Harvard to contribute the full $125,000 to his Cash Balance Plan - even though it exceeds the general 25% deduction limit.
However, he’ll need to adjust his Solo 401(k) employer contribution to make the numbers work.
Exception #1: Required Cash Balance Contributions Are Always Deductible
If your actuary determines that a certain minimum contribution is required to fund the Cash Balance Plan (under IRS §412 funding rules), that amount is fully deductible—even if it exceeds the usual 25% cap.
In Dr. Harvard’s case:
25% × $325,248 = $81,312
Required DB contribution = $125,000
He can still deduct the full $125,000 even though it exceeds the 25% cap.
Nice!
Exception #2: The 6% Carve-Out Rule (Two-Prong Test)
Now for the even better news—the 6% carve-out rule, which may even allow an additional employer contribution on top of the cash balance plan contribution.
Here’s how it works:
Prong #1: If the Solo 401(k) employer contribution is 6% or less of net SE income → the 25% limit doesn’t apply at all.
Prong #2: If it exceeds 6% → then only the amount above 6% counts toward the 25% combined limit.
Let’s run the numbers:
6% of net SE income = $19,515
Dr. Harvard’s planned Solo 401(k) employer contribution = $47,000
→ since this exceeds 6%, we apply Prong #2.
Excess over 6% = $47,000 - $19,515 = $27,485
Now we calculate his “countable” contributions using Prong #2
Cash Balance Plan (DB) contribution: $125,000
Solo 401(k) excess (DC countable portion): $27,485
Total countable contributions: $152,485
🚫 Still way over the $81,312 limit → he fails the 25% combined deduction limit test.
The Fix: Limit the Employer Contribution to 6% (to Take Advantage of Prong #1)
To maximize the combined DB + DC plan deduction, Dr. Harvard can reduce his Solo 401(k) employer contribution to 6% of SE income - $19,515.
This way, he can rely on Prong #1, which allows him to disregard the 25% combined deduction cap entirely.
Here’s what his 2025 deductible contributions now look like:
Elective deferral: ✅ $23,000 (unaffected—it’s made as the “employee”)
Employer contribution: ❌ $47,000 → ✅ reduced to $19,515
Cash Balance Plan contribution: ✅ $125,000 (fully deductible)
The result?
He gives up $27,485 in Solo 401(k) employer contribution space to make room for the larger tax deduction from the Cash Balance Plan.
Still a powerful tax shelter - but not without trade-offs.
So Was It Worth It?
Here’s the net result for Dr. Harvard:
+ $125,000 shelter via the Cash Balance Plan
– $27,485 lost from the Solo 401(k) employer contribution
= $97,515 net increase in tax shelter
Not bad at all —
But not quite as magical as the full $125,000 originally promised.
Final Thoughts
Cash Balance Plans can be a powerful tax shelter — but they come with strings attached.
They generally require annual funding, and you’ll need help from an actuary (at the very least). And if you are not careful, they can quietly cannibalize your Solo 401(k) employer contribution.
Before jumping in, ask yourself:
Am I okay losing part of my Solo 401(k) deduction to make room for the Cash Balance Plan?
Will the net tax savings still make sense after running the numbers?
Can I realistically commit to funding a plan like this for the long haul (see my earlier article on long-term obligations imposed by ERISA)
Like most advanced tax strategies, a Cash Balance plan isn’t a one-size-fits-all solution.
It’s powerful - but only if you know what you’re signing up for.
Disclaimer: click here