This is a Guest Post from RJ Weiss. RJ is an aspiring financial planner, who runs his own website, Our Financial Planner.
Passive income doesn’t have to stop once the money is earned. Wouldn’t it be nice to earn passive income, off passive income?
This step isn’t for beginners. If your passive income isn’t enough to cover your bills, continue using this website for guidance to get you there.
Since the title of this blog is Smart Passive Income, this post will show you the most efficient way of turning passive income into more passive income.
The probable structure of your business, being that you’re a “solopreneur,” allows you to receive an extraordinary tax break, plus a great investment opportunity. Due to your structure, you’re allowed to create and design your own retirement plan, known as an Individual or Solo 401K.
Eligibility
Individual 401K’s are for individuals, partners, and their spouses only. If you’re just starting your business, and plan to grow it with employees, don’t start a Solo 401K.
Businesses whom are likely to take advantage of this opportunity are freelancers, solo proprietors, owners of S Corps, partnerships, and LLC’s.
The Benefits
You create your own retirement plan. Everything from picking the provider, to “employer” contributions, you have complete control over everything.
The biggest benefit an Individual 401K has is very high contribution limits. The amount you can contribute to an Individual 401K trumps other options your business has for retirement savings like SIMPLE and SEP IRA’s.
In 2009, if you’re under 50, the maximum contributed to an Individual 401K isn’t to exceed $49,000. This consists of your salary deferral plus the business’s contribution. You’re salary deferral is maximized at $16,500. The business can then contribute any amount, but not to exceed $49,000 including your salary contributions or 25% of W-2 earnings.
To sort all this out, let’s look at a real life example of someone who owns their own corporation making $40,000 a year.
| No Plan | Solo 401K | |
|---|---|---|
| Net Income | $40,000 | $40,000 |
| Less Salary Deferral | 0 | 16,500 |
| Less Company Match | 0 | $10,000 |
| = Taxable Income | $40,000 | $13,500 |
Your $25,500 investment is then able to grow tax deferred. Meaning in 15 years, at 8%, $25,500 turns into $808,903 before tax. Imagine the results if you’re able to do this year after year.
Where to Set One Up
Use a low cost investment provider like Vanguard or Fidelity. The benefits of having a tax savings vehicle can quickly be washed away by paying extraordinary fees. These two companies provide plenty of investment options, with minimal account fees.
What to Invest In
Just like passive income, passive investing also has its benefits. Using a passive strategy for investing equates to picking a well diversified portfolio of index funds. Over the long term-term, you’re able to minimize costs, and most importantly, take your irrational behavior out of the equation.
The true passive option, when it comes to investing is selecting a target retirement fund. All you need to do is pick a date. The rebalancing and asset allocation is done for you automatically.
My Experience
Most of this information was obtained from a course I’m taking to get my CFP certification. Before you make any changes, check with your CPA. This is a great example of how a good CPA, can easily pay for its services with one decision.
There is a lot more to know when it comes to taxes and investing. The purpose of this post, was to introduce you to something new, that you might be able to take advantage of. For more information visit:
Feel free to read more from RJ at his website, Our Financial Planner
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{ 22 comments (Click Here to Leave a Comment Below) }
Great post. 401k is the way to go. I love the spreadsheet which breaks it down even further.
Vik Dulat´s last blog post..How I enjoyed a $735 weekend for $28
Thank you!
I figured not everyone will be ready for this step, like myself. However, it’s always good to know the gold that’s at the end of the road with a little hard work.
This is great information. I am not ready to take this step, but it is so good to know that this is an option. Thank you for sharing.
Jennifer´s last blog post..Friday Thought On Happiness
I just started “freelancing” this year and have earned $1800 so far. I also have a day job without a 401(k) of any sort. I am looking into setting up a Solo 401(k) with Fidelity but have no idea how to handle taxes on this. Should I have formally created a Sole Proprietorship or LLC before having done any work this year? I have done nothing formally in terms of registering with the gov’t. What next step should I take to “protect” this money? Assuming I only make this amount from freelancing, should I even register as a formal business? My state is SC. Thanks!
@me3, I tutor on the side as a self-employed contractor and have not officially registered my business. I report my income for tax purposes as it is against the law not to. There is no need to formally register anything. It might be a good idea to do so. Pat wrote a post earlier about setting up an LLC and mentioned the pros and cons. Don’t forget to make quarterly tax payments.
Steve @ Start-Up´s last blog post..How to Calculate your Self-Employment Tax and Solo 401k Contribution
Not being familiar with your laws, it’s hard to say. You can earn income without registering as a business. You just have to report it. Here’s is an IRS article that might help you – http://www.irs.gov/newsroom/article/0,,id=175963,00.html
Registering as a formal business can have a lot of benefits. In my opinion it’s easily worth the expense up front, not to mention the liability protection.
I would wait till after April 15, and sit down with a CPA who you explain your situation to.
RJ Weiss´s last blog post..Understanding Bonds: What are Bonds?
I’ve never met a person who’s made a dime with a 401k. I have to say, I think of them as a type of scam. Literally- ask around and find out if anyone you know has ever made any money in one at the end of their term. that doesn’t men money on paper, I mean for the long haul. I wonder if anyone ever has. I’ve had at least 15 people tell me that they wished they’d never put any money in their 401k. You can make more by putting it under a mattress.
@LS, Wow I hope you’re kidding. You in fact make no money by putting it under the mattress. That’s actually the definition of putting money under the mattress. 401k’s are wonderful investing opportunities.
Steve @ Start-Up´s last blog post..How to Calculate your Self-Employment Tax and Solo 401k Contribution
I hope to take this step this year. I really like the breakdown you provided as it helps to visualize everything.
pfincome´s last blog post..Peer Lending – Review of 2008 Prosper Rate of Return
Very interesting — I wonder if it would make sense to max out a Roth IRA first, though, because of the tax benefits of a Roth? Someone with better financial planning skills than myself needs to tackle tat one.
Maria — WriterGig´s last blog post..What is Blogging?
Maria….A Roth IRA and an Individual 401K are both great investments. There is no problem with doing both. As a general rule of thumb, if you think your income will be going up, choose a Roth. If you think your income will be stable or lowering choose a 401K. Unfortunately, it’s hard to find a company that administers a Roth Individual 401K. Also, if you’re planning on making six figures soon, contribute to a Roth IRA while you can. Just some things to think about before you make your decision.
As for LS, your right nobody has made money lately investing in stocks. However, you’re forgetting about the tax savings you get. If you’re in the 25% tax bracket and contribute $10,000 that’s the same as $2,500 in cash. For an investors that doesn’t have the risk tolerance, there are plenty of investments out there that at least maintain inflation.
RJ Weiss´s last blog post..Investing in Bond Mutual Funds
@RJ Weiss, Vanguard allows you to contribute to a Roth Individual 401k.
I opened my Vanguard Individual 401k right at the end of 2008. I really liked the low cost investing options that Vanguard provides. I chose to open an individual 401k so I didn’t have to worry about quarterly estimated taxes as I put all of my self-employed income into my 401k.
@Steve @ Start-Up, I was sort of getting at this in my comment above. I’m not sure how it works, but I question whether payroll taxes must be deducted from your earnings before determining how much one can put in a Solo 401(k). This is assuming what you made was under ~$15k. Where did you get your basis for being allowed to contribute everything you earned? This is exactly what I want to do.
@me3, I don’t know if I can answer the payroll taxes question. My most recent blog post shows how I calculated my 401k contribution. Vanguard also has a pretty nifty contribution calculator that shows you how much you can contribute in the various retirement savings vehicles. It’s all based on net business profit.
https://personal.vanguard.com/us/SbsCalculatorController
Steve @ Start-Up´s last blog post..How to Calculate your Self-Employment Tax and Solo 401k Contribution
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Great info Pat, too bad I’m still a small fish and no where near to even having to think about this yet.
Another thing to consider would be a Roth IRA. You pay with after tax dollars but your contributions (at eligibility would be tax free). So if you turn $20,000 into $800,000 then that $780,000 profit would be tax free.