The 401K plan is named after the related subsection of the Internal Revenue Code. In the past, small business owners avoided this plan because of the discriminatory tests rules. These tests were designed to prevent discrimination against lower paid employees. Under this tests, highly compensated employees/ owners cannot elect to defer a greater percentage into their 401K. For this reason, small business owners chose to invest in the IRA, SEP or SIMPLE IRA. The downside is these alternative plans do not allow for as much deferred contributions.

Lifestyle entrepreneurs have the option of choosing from a solo 401k if they have no employees or safe harbor 401k. With a safe harbor 401k you will only need to make contributions according to the safe harbor rules which are not as stringent as the discrimination rules.

As the owner of your business you play 2 roles.

The first role is that of an employee and the second role is that of an employer

Employee: as an employee of your lifestyle business, you are allowed a maximum contribution of $17,500 in 2014.

Employer: As the employer of your lifestyle business, you have the flexibility of determining your limit. The total employee plus employer contribution cannot exceed $52,000 in 2014. This means you can choose to contribute 17,500 as an employee and 34,500 as an employer for a total of 52,000. However, to be eligible for this maximum contribution you have to pay yourself at least $182,200 for 2014. This is because an employer’s contribution to a 401K for 2014 is limited to 25% of combined wages of all participants (corporation) or 20% of net self-employment income (sole proprietor).

For example:

George is a 30-year-old freelancer. He netted $45,000 from his self employment income. George would be able to contribute:

•    $17,500 as an employee contribution

•    $8,311.50 as an employer contribution computed as 20% of self employment income after half self employment tax adjustment.

Total maximum contribution for income of $45,000 = $25,811.50

If you are over 50, you are able to make catch-up contributions of $5,500.

Further limitations exist if you participate in an employer’s retirement plan. You are limited to a maximum of $52,000 or 100% of your total compensation for the year.

 

Effect of 401k Contributions

Let us take a look how assets can build up for this 30 year old over time:

 

Assumptions

Current Age 30

Date to start living on retirement funds – 65

Life expectancy – 90

Investment rate of return – 10%

 

Making the annual contribution of $25,811.50 as computed above, George will have $7,695,100 by the time he hits 65. Moreover, he will be able to withdraw $95,000 (adjusted for inflation) until he reaches 114.

This is just from his 401k contributions. We have not even talked about the residual income from his lifestyle business. George will definitely be in a good place financially by the time he hits 65. It is no secret that the older you get, the less you are able to work. So why not use your stronger years to plan for the older years. In that way, when you are older, you can choose to just volunteer your time to causes you care about and not have to worry about money.

Go to part 1 of series   401K   Simple IRA   SEP IRA   Payroll Deduction IRA   Profit Sharing Plan