• What is it?
• When can it be used?
• How does it work?
• Advantages to consider
• Disadvantages to consider

A solo 401(k) plan is really nothing more than a combined profit-sharing plan and 401(k) plan implemented by a self-employed individual or small business owner with no full-time employees (unless the full-time employee is the owner's spouse).

Self-employed individuals and small businesses have, for some time, been able to establish both a profit-sharing plan and a 401(k) plan. Prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("2001 Tax Act"), however, establishing both plans had little relative appeal. Self-employed individuals and small businesses adopting employer-sponsored retirement plans largely focused on simplified employee pensions (SEPs) or savings incentive match plans for employees (SIMPLE) IRA plans. These plans generally offered benefits somewhat comparable to those offered by profit-sharing plans and 401(k) plans, but without the associated administrative costs. Additionally, self-employed individuals and small business owners who established profit-sharing plans received little in the way of additional benefit from utilizing a 401(k) plan as well.

Changes made by the 2001 Tax Act, though, have made 401(k) plans much more appealing to self-employed individuals and small business owners. In fact, when combined with a profit-sharing plan, 401(k) plans can allow for significant tax-deferred contributions.

Tip: A solo 401(k) plan allows a self-employed individual or small business owner to maximize tax-deferred retirement contributions. It is, however, really just a simple 401(k) plan coupled with a profit-sharing plan. For detailed information on 401(k) plan features see 401(k) Plan . For detailed information on profit-sharing plans see Profit-Sharing Plan .

Tip: Although the term "solo 401(k)" has become popular, these plans are often referred to by other names, including single-participant 401(k)s and mini 401(k)s.

Caution: Throughout this discussion, references are made to the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Tax Act). It is important to note, however, that unless extended, the provisions of the 2001 Tax Act relating to employer-sponsored retirement plans will expire at the end of 2010. For tax years beginning after December 31, 2010, the retirement plan provisions that existed prior to the 2001 Tax Act would apply.

Any nongovernmental organization is eligible to establish a 401(k) plan. However, only self-employed individuals or businesses with a single owner-employee can adopt a solo 401(k) plan as described here. The fact that you, as a business owner, employ your spouse does not prevent you from adopting a solo 401(k) plan. The fact that you have one or more part-time employees who work fewer than 1,000 hours a year (and therefore can be excluded from participation in the plan) also may not prevent you from adopting a solo 401(k) plan.

Caution: If you have any (nonspouse) full-time employees age 21 or older (or part-timers working more than 1,000 hours a year), you will generally be required to allow them to participate in the plan. In this case, you can still adopt a 401(k) plan, but it will not be a solo 401(k) plan as described here.

Tip: The reason that you can generally adopt a solo 401(k) plan even though you employ your spouse has to do with nondiscrimination testing. You, as the business owner, are considered a highly compensated participant. Your spouse, because of special attribution rules, is also considered a highly compensated participant. A plan that covers only you and your spouse, then, includes only highly compensated participants.

Tip: Because only highly compensated employees participate in the plan (since the plan covers only you and possibly your spouse) a solo 401(k) is not subject to nondiscrimination testing. This greatly simplifies administration of the plan. Were the plan to include any non-highly-compensated employees, nondiscrimination rules would apply and the overall simplicity of the plan would be defeated.

Compensation deferral

As with any 401(k) plan you, as an owner-employee, are able to defer up to $12,000 in compensation in 2003 ($11,000 in 2002). This amount will increase to $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006.

Tip: After 2006, the $15,000 limit will be adjusted based upon the cost of living.

If you are age 50 or older, you are able to make an additional "catch-up" contribution of $2,000 in 2003 ($1,000 in 2002). The catch-up contribution limit will increase to $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006.

Profit-sharing contribution

The 2001 Tax Act increased the maximum deductible amount an employer could contribute to a profit-sharing plan from 15 percent to 25 percent of total eligible compensation under the plan. Significantly, the 2001 Tax Act also provides that compensation deferred as part of a 401(k) plan does not count toward the 25 percent limit. Therefore you, as an owner-employee, can defer the maximum amount of compensation under the 401(k) plan, and still contribute up to 25 percent of total compensation to the profit-sharing plan on your own behalf.

Tip: In calculating total eligible compensation under the plan, the maximum compensation that can be considered for any single individual is $200,000.

Tip: If the business is unincorporated, solo 401(k) plan compensation is based upon net earned income. This means that self-employed individuals must deduct one-half of their self-employment tax as well as any plan contributions to determine their compensation base. Effectively, this means that a unincorporated business with one owner-employee can deduct contributions of up to 20 percent of the owner-employee's earnings after the deduction for one-half of self-employment tax.

Example(s): 30-year old Jack is the sole owner of a small corporation, and he has annual pretax compensation of $20,000. Since he has no employees, he is the only participant in his business's 401(k) plan. Under current tax law, Jack's plan account can receive a tax-deductible business contribution of $5,000 (25 percent of $20,000), plus a 401(k) elective deferral contribution of $12,000. This combination results in a total contribution of $17,000 for the current tax year, well within Jack's annual additions limitation of $20,000 (the lesser of $40,000 or 100 percent of his pretax compensation).

Now assume the same facts as above, except that Jack is a sole proprietor instead of the sole owner of a corporation. In this case, Jack's plan account can receive a total contribution of up to $15,717.40 for the current tax year--a $3,717.40 tax-deductible business contribution (20 percent of Jack's net earnings reduced by one-half of self-employment tax), plus a 401(k) elective deferral contribution of $12,000.

Annual addition (415(c)) limit

The 2001 Tax Act also increased the maximum amount that a participant can receive in the form of combined employee deferrals and employer contributions to the lesser of 100 percent of compensation or $40,000. This means that the total of your compensation deferral and profit-sharing contribution cannot exceed $40,000 in a single year.

Tip: Prior to the 2001 Tax Act, the maximum amount that a participant could receive in the form of combined employee deferrals and employer contributions was the lesser of 25 percent of compensation or $30,000 (adjusted for the cost of living to $35,000 in 2001).

This limit does not apply to catch-up contributions made by individuals age 50 or older. These individuals may exceed the annual addition limit by an amount equal to their allowable catch-up contribution (e.g., $2,000 in 2003).

A qualifying self-employed individual or small business owner seeking to put aside the maximum amount of funds for retirement on a tax-deferred basis really can't do much better than a solo 401(k). Moreover, given the flexibility of being able to determine each year how much to contribute (or whether to contribute at all), a solo 401(k) becomes a very powerful retirement savings vehicle. A solo 401(k) may be particularly appealing to individuals who have full-time careers, but have their own sideline businesses. Such individuals could potentially contribute a large portion, if not all, of the sideline business earnings into a solo 401(k).

Caution: An individual already participating in an employer-sponsored retirement plan must be careful. Compensation deferrals and total amounts received under the plans must be coordinated. Consult a retirement plan professional.

Additionally, like all 401(k) plans, solo 401(k) plans can allow loans, and may allow hardship withdrawals (withdrawals made prior to age 59 ½ may be subject to a 10 percent federal penalty tax). You can also roll over funds to your solo 401(k) plan from a former employers 401(k) plan and from other types of retirement arrangements, including IRAs, SEP and Keogh plans, and Section 457(b) plans.

Like a regular 401(k) plan, a solo 401(k) plan must follow certain requirements under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC). Since you are generally the only participant in a solo 401(k) plan, meeting these requirements isn't nearly as difficult as with plans that have multiple participants. Additionally, solo 401(k) providers will typically bundle the product with administrative support. However, there is still a cost associated with establishing a solo 401(k), as well as a cost relating to the plan's ongoing administration.

Another issue to consider is whether a solo 401(k) will meet your future needs. If your business grows and you hire a full-time employee who is not your spouse, that employee will generally need to be covered by your retirement plan. If that happens, you're no longer dealing with a solo 401(k), but a full-blown qualified plan subject to all coverage and discrimination rules.

In addition, since a solo 401(k) plan is a one-participant plan, many providers offer a relatively limited selection of investment alternatives. However, as solo 401(k)s gain in popularity, more investment options should become available.

Finally, self-employed individuals and small business owners with significant compensation (e.g., $160,000 or greater) can already contribute a maximum $40,000 by using a traditional profit-sharing plan or SEP plan. Since solo 401(k) plans are subject to the same $40,000 limit, no advantage is gained when it comes to contributions, with the possible exception of catch-up contributions that can be made by individuals age 50 or older.

Click here for the .PDF version of this article.