The Solo 401(k) - Self Employed 401k

And there's more: You can contribute and deduct an additional amount of up to 25% of your compensation income, or 20% 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 $33,000 [$13,000 + (25% of $80,000)]. That's a lot more than the $20,000 you could contribute to a traditional plan (25% of $80,000).

Now say you earn $80,000 from your sole proprietorship. The maximum solo 401(k) contribution would be an impressive $29,000 [$13,000 + (20% of $80,000)]. With a traditional plan, your maximum contribution would have been a mere $16,000 (20% of $80,000).

If you're 50 or older, your maximum solo 401(k) contributions for 2004 would be $36,000 [$16,000 + (25% x $80,000)] and $32,000 [$16,000 + (20% x $80,000)], respectively.

And for 2005 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 each year through 2006 (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 2004 is $41,000, or $44,000 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 $46,000 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 Dec. 31 if you want to claim a 2004 tax deduction.