There are several varieties of tax-favored retirement plans available for solo entrepreneurs. In this two-part post, I’ll highlight the characteristics of each and detail the factors you should consider before making your choice.

First, you should only consider establishing a retirement plan for your solo business after you have achieved a sustainable profit margin. As you will see, that profit margin doesn’t have to be huge, but it doesn’t make sense to fund a long-term retirement program until your business is on a solid, profitable footing.

Next, these posts address only solo entrepreneurs, defined as businesses with no W-2 employees (with the exception of a spouse who is employed by the business– the plans that are discussed do allow for husband and wife owners/employees to both be covered).

If you have non-spouse employees or anticipate hiring non-spouse employees, these plans are probably not appropriate for you (with the exception of #1 below which may be an option even if your business has employees).

Now, let’s look at the various plan types:

1) IRAs (Individual Retirement Arrangements)

IRAs are available to any taxpayer with earned income. You may contribute the lesser of earned income or $4,000 ($4,500 if over age 50). Spouses with no unearned income can contribute to their own IRA based on their working spouse’s income (i.e., assuming one spouse earns at least $8,000, each spouse could contribute $4,000 to their own IRA even if the non-working spouse has no earned income).

IRAs get a little tricky because there are two varieties:

Traditional IRAs allow tax-deferred growth on your contributions. Taxes are paid upon withdrawal at your ordinary (ie, marginal) income tax rate. Contributions may or may not be deductible depending on your income and your participation in other retirement plans.

Roth IRAs afford no tax deduction for contributions but allow tax-free (not just tax-deferred) growth. Roth IRA eligibility is limited based on your income.

IRA contributions may be made in addition to any contributions made to the types of plans that follow.

2) SEP-IRAs (Simplified employee pensions) allow you to contribute and deduct the lesser of $45,000 (for 2007) or 20% of self-employment income (25% of salary if you’re an employee of your own corporation).

SEPs can be opened up as late as the extended due date of your income tax return and can be quickly and easily set up, usually at minimal expense — with a bank, brokerage firm or insurance company.

No annual government reports are required, and ongoing administrative expenses are usually zero. SEPs operate almost identically to traditional IRAs but allow much higher contributions and deductibility is not limited by an income ceiling.

3) Solo 401(k) Plans

These are “micro” versions of the 401(k) plans that large companies offer their employees.

There are two big advantages of a solo 401(k) plan over a SEP-IRA: you don’t have to earn as much as you do with other retirement plans to qualify for the maximum tax-deductible contribution (for 2007, you can contribute up to 100% of your first $15,500 of self-employment income), and some solo 401(k) plans allow for a Roth option (similar to the above explanation of Roth IRAs although the 401(k) variety is not subject to income ceiling limitations and the contribution amount is much higher than with a Roth IRA).

Because these are “qualified” plans, setting them up is slightly more involved and such plans must be set up before the end of your company’s fiscal year (usually 12/31).

The downside to this type of plan is that it has slightly higher administrative expenses and requires an annual IRS filing once the plan assets reach a certain level.

4) Defined Benefit Plans

Solo defined benefit plans are more complicated and expensive than the plans listed above. The advantage to these plans is that (in the right circumstances) they allow very large, deductible contributions by the owner. These plans typically require an attorney to setup the plan and an actuary to annually evaluate the funding and the required contribution to the plan; thus, the administrative expenses to setup and maintain these plans are high relative to the other plan options.

5) Keogh Plans (Profit Sharing and Money Purchase)

With the creation of solo 401(k) plans and liberalization of contribution rules for SEP-IRAs, these plans are largely going by the wayside and are generally inferior to the choices shown above. I mention them because there are still businesses that have such plans, and also because the term “keogh” is still sometimes used in a generic way to refer to any “self-employed retirement plan.”

So which plan should you choose? Stay tuned for part two of this post…

Please read the Disclosure.

Visit John’s blog Christian Money Talk and his Web site Frisco Financial Planning.