If you're self-employed or own a small business, you've probably considered establishing a retirement plan. If you've done your homework, you likely know about simplified employee pensions (SEPs) and savings incentive match plans for employees (SIMPLE) IRA plans. These plans typically appeal to small business owners because they're relatively straightforward and inexpensive to administer. What you may not know is that in many cases an individual, or solo, 401(k) plan may offer a better combination of benefits. A solo 401(k) plan is worth considering if you're looking to set up your first retirement plan or want to switch to a different plan.

A solo 401(k) plan is a regular 401(k) plan combined with a profit-sharing plan. However, unlike a regular 401(k) plan, a solo 401(k) plan can be implemented only by self-employed individuals or small business owners who have no other full-time employees (an exception applies if your full-time employee is your spouse). If you have full-time employees age 21 or older (other than your spouse) or part-time employees who work more than 1,000 hours a year, you will typically have to include them in any plan you set up, so adopting a solo 401(k) plan will not be a viable option.

Note: A solo 401(k) plan isn't really a different kind of 401(k) plan. Rather, it simply takes advantage of the fact that relaxed rules apply when the only individuals who participate in the plan are the owner and the owner's spouse.

One feature that makes a solo 401(k) plan an attractive retirement savings vehicle is that in most cases your allowable contribution to a solo 401(k) plan will be as large or larger than you could make under another type of retirement plan.

With a solo 401(k) plan you can elect to defer up to $13,000 of your compensation to the plan for 2004 ($16,000 if you are age 50 or older by the end of the calendar year), just as you could with any 401(k) plan. In addition, as with a traditional profit-sharing plan, your business can make a maximum tax-deductible contribution to the plan of up to 25 percent of your compensation (slightly less than that if you are a sole proprietor or unincorporated).

Because the amount of compensation deferred as part of a 401(k) plan does not count toward the 25 percent limit, 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. Total plan contributions for 2004 cannot, however, exceed the lesser of $41,000 or 100 percent of your compensation.

For example, Dan is 35 years old and is the sole owner of an incorporated business. His compensation in 2004 is $80,000. Dan sets up a solo 401(k) plan for his retirement. Under current tax law, Dan's plan account can accept a tax-deductible business contribution of $20,000 (25 percent of $80,000), plus a 401(k) elective deferral contribution of $13,000. As a result, total plan contributions on Dan's behalf equal $33,000, which falls within Dan's contribution limit of $41,000 (the lesser of $41,000 or 100 percent of his compensation).

These contribution possibilities aren't unique to solo 401(k) plans; any business establishing a regular 401(k) plan and a profit-sharing plan could make similar contributions. But solo 401(k) plans are simpler to administer than other types of retirement plans. Since they cover only a self-employed individual or business owner and his or her spouse, solo 401(k) plans are not subject to the often burdensome and complicated administrative rules and discrimination testing that are generally required for regular 401(k) and profit-sharing plans.

Note: Solo 401(k) plans weren't always so attractive. Prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Tax Act), 401(k) contributions had to be counted toward the business's maximum profit-sharing contribution (which was itself limited to 15 percent). It should be noted here as well that, unless extended, the provisions of the 2001 Tax Act that impact 401(k) plans and profit-sharing plans expire at the end of 2010. For tax years beginning after December 31, 2010, retirement plan provisions that existed prior to the 2001 Tax Act apply.

Large potential annual contributions and straightforward administrative requirements are appealing, but solo 401(k) plans also have other advantages, which are shared by many other types of retirement plans:

• A solo 401(k) is a tax-deferred retirement plan, so you pay no income tax on plan contributions or earnings (if any) until you withdraw money from the plan. And, your business's contribution to the plan is tax deductible.
• Contributions to a solo 401(k) plan are completely discretionary. You should always try to contribute as much as possible, but you always have the option of reducing or even suspending plan contributions if necessary.
• A solo 401(k) plan can allow loans and may allow hardship withdrawals if necessary.
• A solo 401(k) plan can accept rollovers of funds from another retirement savings vehicle, such as an IRA, a SEP, or a previous employer's 401(k) plan.

Despite its attractive features, a solo 401(k) plan is not the right option for everyone. Here are a few potential drawbacks:

• A solo 401(k) plan, like a regular 401(k) plan, must follow certain requirements under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC). Although these requirements are much simpler than they would be for a regular 401(k) plan with multiple participants, there is still a cost associated with establishing and administering a solo 401(k) plan.
• Institutions offering solo 401(k) plans often provide limited investment choices. However, investment options are likely to increase in the future as demand for the solo 401(k) increases among small business owners.
• Self-employed individuals and small business owners with significant compensation (e.g., $165,000 or greater) can already contribute a maximum $41,000 by using a traditional profit-sharing plan or SEP plan. A solo 401(k) plan will not allow contributions to be made above this limit (an exception exists for catch-up contributions that can be made by individuals age 50 or older).
• A solo 401(k) may not 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 included in your plan. If that happens you no longer have a solo 401(k) plan; you have a regular 401(k) plan and profit-sharing plan, and you lose the benefit of the solo 401(k) plan's simplified administration rules.