What You Need to Know About the Solo 401(k)

In the world of retirement accounts, the 401(k) is definitely one of the best. A tax deferred account, you can reduce your taxable income by investing into this little beauty and with the 2006 pension law signed by President Bush, anyone, including children and other heirs can inherit a 401(k) account and transfer the funds into their own retirement account without any immediate taxes due.

In addition, you can contribute up to $15,500 per year (as of 2007) to a 401(k) plan while an IRA limits contributions to $4,000 per year. That's a huge difference if you're trying to catch up on retirement funding and/or trying to reduce your taxable income as much as possible.

The problem with 401(k)'s is that they are employer-sponsored programs. Not a big deal if you're working for someone else but given the growth of startup businesses, it would appear that many Americans are looking for a way to work for themselves. But do we really have to give up the benefits of employer-sponsored retirement accounts to enjoy the freedoms that come with being self-employed?

Not anymore.

Also called an Individual or Self-Employed 401(k), this retirement option is essentially a true 401(k) plan designed exclusively for the self-employed. Like its corporate counterpart, the Solo 401(k) offers the ability to make monthly contributions to your retirement account on a pre-tax basis. As the employer, you can also choose to match a portion of those contributions, giving you the abilityto maximize your tax deferral options. For 2007, the maximum employer contribution is 25% of compensation for corporations or 20% of self-employment income.

What does this mean for you?

In addition to the $15,500 you as the "employee" can contribute, you can also add an additional 20 to 25% as an employer match. See the benefits adding up?

And here's the beauty part: during those slow times when your cash-flow is tight, you can reduce your contributions or contribute nothing at all.

To qualify for a Solo 401(k) you must be a one-person show, with the exception of your spouse. That means no employees (again, spouse excluded) on your payroll.

Why the limitation?

Because tax laws say that if you contribute to an employee's 401(k), you must make the same contribution to all employees. The Solo 401(k) isn't set up for that since you can, at your discretion choose how much - if any - you'll be contributing for any given year.

As a sole proprietor, you can choose to contribute or not contribute without any ramifications to any outside party. But if you have employees... well, how do you think they'd react if you told them the matching 401(k) wasn't going to happen this year?

So, to head off these complications, the Solo 401(k) is limited to true solo companies. If you start hiring employees, you'll need to look into a traditional 401(k) plan.

While the Solo 401(k) is still relatively new, there are plenty of companies already on board with the program. This is good news since you'll be the administrator of your 401(k) plan which requires a little paperwork and who better to help you set it up than someone who specializes in 401(k) administration?

The 401k Help Center has put together a wonderful compilation of Solo 401(k) brokers. Just updated in May, 2007, this comprehensive list will give you plenty of companies to call and compare.

My advice?

Request a packet and then look over the plan. Compare it to other plans as companies can vary in the fees they charge for setup and administration. Also to note, some companies allow for loans against a Solo 401(k) while others don't. If this is an important feature to you, be sure you ask the question before you make the committment to the plan.

And one final thing: to get the tax deductions for 2007, you'll need to set up your plan by December 31st.