The Solo 401(k) Did you know that, even as a business owner, you could participate in a 401(k) plan? Find out more.

Do you run your business as a one-person show? Have we got a deal for you: The so-called solo 401(k) plan got a hefty makeover under the Bush tax cut legislation and is expected to revolutionize the way many self-employed folks save for retirement.

The biggest improvement: much larger deductible annual contributions. This means you can quickly build up a substantial tax-deferred retirement account balance--while cutting your annual income tax bills, to boot.

As you probably know, traditional small-business retirement plans--such as a profit-sharing plan, Keogh or SEP--allow annual deductible contributions equal to 25 percent percent of your compensation (if you've set up your business as a corporation) or 20% of your self-employment income (if you're a sole proprietor), with a maximum dollar cap of $42,000 for 2005 ($46,000 if you are age 50 or older as of December 31, 2005).

So, say your solely owned corporation pays you an $80,000 salary. The maximum deductible contribution to a company profit-sharing plan set up for your sole benefit would be $20,000 (25 percent of $80,000). Now, say you earn $80,000 of self-employment income from your sole proprietorship. In this case, the maximum deductible contribution to your self-employed Keogh or SEP account would be $16,000 (20 percent of $80,000).

Not bad, but you might wish you could funnel more (maybe a lot more) into your tax-favored retirement program. After all, assuming you have the cash to do so, bigger deductible contributions lower your tax bills and generate more tax-deferred earnings for your retirement stash as well. It's a tax-saving double play.

The Solo 401(k) Alternative
Enter the solo 401(k) plan. For those who are looking to max out their contributions to a deductible retirement account, it's a major improvement. The reason: With a solo 401(k), annual contributions consist of two parts. And in this case, two is definitely better than one.

First, you can contribute up to 100% of the first $14,000 of your 2005 compensation or self-employment income ($18,000 if you'll be 50 or older at year-end). For 2006 and beyond, the numbers will rise to $15,000 ($20,000 if you'll be 50 or older at year-end).

And there's more: You can contribute and deduct an additional amount of up to 25 percent of your compensation income, or 20 percent of your self-employment income. This second part of your annual contribution is like what you can do with a traditional small-business retirement plan (mentioned above).

To see how the two parts stack up, let's go back to our examples.

Your corporation pays you $80,000 this year. The maximum deductible contribution to your solo 401(k) account would be a whopping $34,000 [$14,000 + (25 percent of $80,000)]. That's a lot more than the $20,000 you could contribute to a traditional plan (25 percent of $80,000).

Now say you earn $80,000 from your sole proprietorship. The maximum solo 401(k) contribution would be an impressive $30,000 [$14,000 + (20 percent of $80,000)]. With a traditional plan, your maximum contribution would have been a mere $16,000 (20 percent of $80,000).

If you're 50 or older, your maximum solo 401(k) contributions for 2005 would be $38,000 [$18,000 + (25 percent x $80,000)] and $34,000 [$18,000 + (20 percent x $80,000)], respectively.

And for 2006 and beyond, the solo 401(k) contribution limits will be even greater, since the maximum contributions under the first part of the deal are scheduled to increase as detailed above.

Of course, if you make more than the illustrated $80,000 from your solo business activity, you can contribute even larger amounts to your solo 401(k). But the absolute dollar cap for 2005 is $42,000, or $46,000 if you're 50 or older at year-end. So as you approach $205,000 of income, the solo 401(k) advantage over traditional plans shrinks, because of the dollar caps. (Going forward, the contribution limits for those age 50 and older will continue to rise, ultimately providing a maximum contribution of $47,000 in 2006.)

Bottom line: For those who hate to leave any tax break on the table (and I hope there are lots of you), the solo 401(k) is one sweet deal. And never fear: You won't be forced to contribute more than you can comfortably afford in years when cash is tight. You can always pay in less than the tax-law maximum or even nothing at all. In other words, the solo 401(k) lets you rack up major tax savings in the good years, while leaving you the option to contribute less (or zero) in the lean years, when conserving cash is your highest priority.

There Must Be a Catch
There are two potential downsides to the solo 401(k) strategy.

First, if you have employees, the tax law may require you to contribute to their accounts as well as your own. But this is an issue with any type of tax-deferred retirement program--including a 401(k). So, if you have employees, please take my advice and hire a competent retirement-plan professional before making any moves.

Second, setting up and operating a 401(k) plan involves some degree of paperwork and administrative nonsense. Fortunately, with a solo 401(k), this is only a minor concern, because you're the only participant. Also, your friendly brokerage outfit is probably poised to assist you in handling all the details. Typically you'll pay a small set-up fee (somewhere around $100) plus an annual fee of $50 to $250. Fidelity, Principal and Salomon Smith Barney, among others, are already in the game. More are sure to follow.

Don't Miss the Year-End Deadline
You must establish your plan by December 31 if you want to claim a 2005 tax deduction.

From SmartMoney.com. Copyright © 2005 SmartMoney.com. All rights reserved.