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"SOLO" 401(K) FLIES TO RESCUE OF SELF-EMPLOYED AT YEAR-END

December 06, 2002

A little-noted provision of the 2001 tax act will gain fame with self-employed taxpayers in the next few weeks. The provision allows self-employed taxpayers to in some cases shelter a big chunk of their net income from self-employment - in some cases, all of it.

This tool, sometimes called the "Solo-k," can also work for sole employees of S corporations.

WHAT DOES IT DO? Self-employed taxpayers can shelter their income two ways with a Solo-k.

1. Taxpayers with a Solo-k plan can make a deductible contribution of up to 100% of their self-employment income to tax-qualified pension plan set up for themselves as a 401(k) deferral, up to $11,000. If they are over 50, they can throw in an extra $1000.

2. Taxpayers can shelter an additional 25% of their net self-employment income (reduced by � of self-employment tax, and, in a circular computation, by the 25% contribution) to the plan as a profit-sharing contribution.

The total contribution cannot exceed the lesser of total self-employment income or $40,000. Once in the plan, the funds build-up tax free until they are withdrawn.

SO IF MY SELF-EMPLOYMENT INCOME IS LESS THAN 11,000... yes, you can put it all into a Solo-k plan (net of � of the self-employment tax).

WHAT IF MY SELF-EMPLOYMENT INCOME IS, SAY, $40,000? Then you may contribute $18,435, consisting of an $11,000 401(k) contribution and a $7,435 profit-sharing contribution:

Self-employment income: $40,000
Less: � SE tax ( 2,826)
Profit-sharing contribution: ( 7,435)
Computation base: $29,739
x 25%
Profit sharing contribution $ 7,435

WHEN DO I HAVE TO PUT THE CASH IN? You have until the due date of your return; if you extend your return, you have until the extended due date.

WHAT'S THE CATCH? The biggest catch is that the plan has to be in place before year end. Some mutual fund companies reportedly are ready to set these up, including Fidelity Management. Some banks also have these plans available.

These plans are full-fledged qualified plans, so they also require annual 5500 reporting; if you set one up, make sure your annual fee for the plan includes this. Because they are qualified plans, they are also subject to strict rules on withdrawals and related party transactions.

If you would like to see how this might affect you, call your Roth & Company tax advisor. To get a quick and dirty estimate, go here.