When you venture out on your own as a small business owner one of the things you lose is an employer sponsored retirement account. Fortunately, there are a number of options available to those who are self employed, such as the SEP IRA, the Simple IRA, and the Solo 401(k). Each one of the self employed retirement accounts have their own list of pros and cons. I’ll review a few of them here.

SEP IRA

The SEP IRA, or Simplified Employee Pension as it is more formally known, is a great option for small business (those with fewer than 10 employees). SEP IRAs allow employers to deposit up to $49,000 or 25% of net earnings, whichever is greater, in a tax year. They are relatively easy to set up, requiring only the completion of an IRS form (IRS Model Form 5305-SEP).

Employees cannot contribute to the SEP IRA, only employer contributions are allowed. SEP IRA plans do allow for contributions to part time employees. In fact, employers are required to contribute to part time employees  over 21 years of age who have worked 3 of the past 5 years and earned more than $500.

SIMPLE IRA

The SIMPLE IRA (SIMPLE stands for Savings Investment Match Plan for Employees) differs from the SEP IRA in that is usually reserved for larger businesses (less than 100 employees). Employees may contribute up to $11,500 per year, and employees over 50 years of age may add an additional $2,500 in catch up contributions.

One of the advantages of the SIMPLE IRA over a traditional 401k is that employer contributions to the SIMPLE IRA are fully vested right away, meaning the employee can take the money with them should they leave. Most 401k plans have a waiting period before employer contributions are vested with employees.

It’s important to note two unique things about the SIMPLE IRA. If you are an employer, you must provide matching funds up to 3% of your contribution. Withdrawals from the SIMPLE IRA before reaching full retirement age of 59 1/2 also carry a steep penalty – 10% early withdrawal penalty plus a 25% penalty if you cash out withing the first two years of contributing to the plan.

Solo 401(k)

A Solo 401k is available for both you and your spouse, and excludes employees who work fewer than 1,000 hours a year. If you have employees who work more on a full time basis, this plan won’t work for your business.

In 2010 you may contribute up to $16,500 of your pre-tax income to a Solo 401k, similar to what you can invest in a regular 401k account sponsored by an employer. If you are over 50 you can add a “catch-up” contribution of $5,500 per year. Employers may also add profit sharing up to 25% of an employee’s pay, but may not exceed $49,000.

Thanks to this profit sharing component, the Solo 401k allows the most possible contributions of the three plans.

Which Self Employed Retirement Plan is Best?

That’s a tough question to answer, because it depends largely on the size of your business, the relationship of your employees (full time, part time, both), and your personal goals for your own retirement. For small businesses, it seems the SIMPLE IRA is the easiest to establish, and provides the most flexibility. For a sole proprietorship, or small partnerships, with significant earnings, the Solo 401k allows for the most contributions, and could be a way to build wealth very quickly.

Recently, my family moved to an envelope budgeting system whereby we spend only cash for basic household categories such as food, entertainment and a few others. We place cash in budget envelopes and spend accordingly. When the envelope is empty, we’re finished shopping for that particular month.

Listed below are the steps we took to implement our envelope budgeting:

• Determine categories for your envelope budget. Not everything in your household budget can fit into an envelope, literally. Things like utilities, subscriptions, and other recurring monthly bills are typically paid online or via bank draft. The real spending categories we are interested in are discretionary spending categories. For our family the typical categories making up our envelope budget are food, household products, gifts, entertainment, and clothing. In the beginning we also included gasoline, but the pay-at-the-pump feature is just too convenient to pass up on a cold, rainy day, so we still use our debit card at the pump. Who wants to carry kids into a convenience store to pay for $30 worth of gas in cash?

• Use past spending to establish initial budget amount. Review your previous month’s spending record to indentify transactions that belong into each spending category you have budgeted. In our case, a $50 Target store transaction may break down accordingly: $25 on groceries, $10 on clothing, $15 on household products. Using your best estimate come up with an average monthly expenditure for each envelope budget category.

• Create a budget envelope for each spending category identified in the previous step. Record the category and monthly amount on each budget envelope. If you are paid twice a month, plan to fill the envelopes on payday, rather than the first of the month. If you have enough cash on hand to fill the first month up front, try a monthly budget plan right off the bat.

• Stop spending for a particular category when budget envelope reaches zero. To guarantee the success of an envelope budgeting plan you have to stick to this rule. When you run out of money in your “Entertainment” budget envelope, you cannot take $20 from “Food” to cover a movie. You have to have the discipline to skip a night out.

The envelope budget is a great way to get a quick handle on your finances. However, I’m not sure it is something that can be sustained long term, simply because of the amount of tracking and planning it requires. If you are in need of a quick budgeting plan, and are currently lacking the discipline to use a debit or credit card, I would definitely give envelope budgeting a long look.

Cashing out and enjoying a life of financial independence first requires the elimination of life’s large expenses. One of the largest expenses many of us face is a mortgage. But the idea of paying off a mortgage early draws many critics.

Unfortunately, mortgages are kind of a necessary evil in today’s society. Real estate prices have reached a level that make paying cash for a home just about cost prohibitive for most families. So, the large majority of us obligate ourselves to pay some ungodly amount each and every month for the next thirty years of our lives. Three decades is a long time.

If you are an up-and-coming thirty-something with a fast-track career and a big income to match you are probably looking to upgrade that starter home you bought a few years back. Of course, I’d much rather stay in the starter home and pay it off early, but I understand most people outgrow starter homes when they have kids.

At 36 years-old you go out and buy a $300,000 house with just enough down to get financing approved. You’ll be 66 years-old before that mortgage loan is paid off. That means for the next three decades you will have to make that big mortgage payment every single month, pretty much guaranteeing you’ll never be able to cash out.

For this reason alone, all the arguments against paying off your mortgage early are void in my book. Sure, you’ll lose some tax advantages, and the money could be invested in the market at a higher rate than your mortgage is financed, etc, etc. But for me, the freedom of not owing anyone money, especially on your home, is priceless.

Just think of how fast you could accumulate serious wealth buy simply investing what would have been a mortgage payment each month. Whether that is $900 a month, or $2,000 a month, it wouldn’t take very long to be able to seriously consider cashing out. Simple math tells us that $2,000 a month for ten years is nearly a quarter of a million dollars, and that doesn’t account for compound growth over that same decade. Imagine how much you could accumulate in three decades!

So decide what you really want – a tax advantage for thirty years, or the chance to be financially independent in less than thirty years. The choice is yours. As for us, well, we are moving forward with our plans to pay off our mortgage so we can start investing even more money towards our cash out nest egg.

So much for those 40-year careers and a fat pension check. Gone are the days of young workers sticking it out with one employer until retirement . Young workers will now likely have several jobs, and several employers in a lifetime. But there is one employer you shouldn’t forget about – yourself. Learn how to create passive income using your current active income, and some day you may be able to live off the passive income.

I firmly believe that everyone should be self-employed in some respect, either by running their own business, or developing a product or idea that continue to pay dividends for years to come. Either way, we have to get outside of the single-employer, single-income stream mentality that many of our parents and grandparents had.

Creating a passive income is not something that happens overnight. It takes many years of accumulating capital, and producing and acquiring things that return passive income to build up enough returns to sustain your lifestyle. However, once you learn how to create passive income you begin to understand the power of things like compounding interest and appreciation.

What is passive income?

The best way to define passive income is to define active income. Active income is money earned by doing work. The salary you earn at your job is active income. The money you earn creating websites on the side is active income. You have to physically perform some action over a period of time to earn that money.

Passive income is the exact opposite of that. For income to be considered truly passive, you have to do nothing to receive it, beyond the initial work to produce the asset. For example, authors earn royalties on books years after they write the book and earn back the advance. As long as those books keep selling, they’ll keep earning royalties.

Same goes for interest compounding on your savings account at the bank. That interest accumulates day after day regardless of what you do or don’t do. It accumulates while you sleep and while you are on vacation, just the same as it would if you stood over it inside the bank vault for 24 hours a day.

Learning how to create passive income is a key element to cashing out early. When you first start building a passive income portfolio, you may only be earning a few dollars a month. But over time, as your working capital grows, so will your passive income. One day, that income may be enough to support your basic expenses and free you from the requirement to earn an active income. This is especially true if you can pay off debts and drive down expenses prior to retiring early.

To build my own passive income portfolio, I have started investing in stocks that yield high dividends (historically). I also am interested in investing in paid-for real estate, and would some day like to write a book or two. The idea is to get started early so you have adequate time to build your passive portfolio with active income.

Ever wonder what it takes to save one million dollars? A lot depends on how soon you get started, how much inflation runs, and how much your savings earn over the years. The later you get started, the more money you have to save each month to hit a one million dollar target. Just how much more? Let’s run the numbers, assuming your goal is to save one million dollars by age 65 and your rate of return is 8%.

At 25 years-old, you’ll need to save $309 a month to be a millionaire by 65. At 25, you probably aren’t thinking much about retirement, and would rather spend that $309 on a new car rather than some forty-year goal of reaching one million dollars. However, if you have the discipline to sock away the money in your company’s 401(k) and a Roth IRA, then chances are you will hit one million dollars.

If you wait just ten years, and at age 35 start saving, you have to save $705 a month to become a millionaire in thirty years. So now you are 35, probably married with a couple kids, two cars and a mortgage payment. Try carving $705 a month out of that budget! By now you are already regretting not starting sooner. It is not too late, by any means, but it will be all uphill from here.

If you wait twenty more years, until you are 45 years-old, you will have to come up with $1,750 a month to hit millionaire status in just twenty years. Ouch! Never too late to get started, but now you move from carving out a little to dedicate to savings to essentially saving the equivalent of a second mortgage payment every month. Those kids are probably in college now, you still have 15 years on the house and you have a little credit card debt to pay off from the vacation you took to celebrate your 20-year anniversary.

Of course, it is worth mentioning that inflation is the silent factor in this discussion. That one million dollars in 20 or 30 years will not be worth nearly as much as it is today, but it will still be a lot of money, so don’t let the discouraging idea of currency deflation keep you from saving. Open up a savings account. Start contributing to your employer’s 401(k) plan. Invest through a Roth IRA in a variety of diversified mutual funds. The bottom line? Get started today!

This post appeared in the Carnival of Best Personal Financial Planning and Personal Investment Articles.

I plan to quit my job in the next 12 months, and I have set July 30, 2010 as my unofficial last day. I use the word “unofficial” because my employer doesn’t know it yet. So, in essense, I have only given myself notice.

While I plan to give a lengthy notice to my employer (probably about a month), I don’t want to tip them off too soon. However, it is important when planning to quit a job to give yourself plenty of notice to arrange things such as insurance (both car insurance and health insurance), emergency savings, etc. Here is a little more about how I arrived at July 30 as my final working date.

How To Put Yourself on Notice

Emergency Savings
I figure it will take me about a year to accumulate enough savings to feel completely comfortable in my decision. My wife and I are nearly debt free, and once that is behind us we should be able to sock away a good deal of money each month into savings. Ideally, I’d like to have a full year of expenses in savings before quitting my job.

Insurance and Other Benefits
By giving myself a notice I have established an end game. Now I know what we must do between now and July 30, 2010 to make early retirement a reality. There will be plenty of things to consider before trading in my employee badge for a pass to work from home! Near the top of the list of things to worry about is health insurance, since it is now provided by my employer. When I walk away from employment I will also have to compensate for a loss of a 401(k) match, employer-sponsored life insurance, disability insurance, and a number of other fringe benefits. I’ll need plenty of time to research and acquire these policies before I leave the office to work on my own.

Equipment Upgrades
Before venturing out on my own I will need to upgrade some computer equipment. I manage to scrape by doing freelance writing now using an old desktop computer, and my PC at work (on lunch breaks). When I become self-employed I’ll need more reliable equipment, and better to recognize that now and cashflow these purchases while I still have a regular paycheck.

Employer’s Needs
I am part of a team working on a special project that will likely take most of the next year to complete. Before I walk away, I want to help see the project to a successful implementation. My company, and the people there, have been good to me, and I certainly don’t want to leave them in the lurch. That said, finding the right time to ease out of the building is a balancing act between my own needs and the needs of the company. While I tend to look out for myself and my family first, I also recognize loyalty is a two-way street, and I feel an obligation to follow through on my part of the project.

After taking all of these various factors into consideration I decided a year was a conservative estimate for the amount of time necessary to meet my savings goals, obtain insurance, upgrade technology equipment, and finalize projects with current employer. My last day at work will be July 30, 2010. I’m now officially on notice.

Photo by Attempts at Photography

As a visual person, I very much appreciate graphical motivators such as wall charts and the like. Whether you are tracking weight loss, or progress towards early retirement, a wall chart can be a powerful tool.

This concept was first introduced to me in the book Your Money or Your Life. The book’s authors advocated creating a retirement chart to track passive income and expenses. The idea was that as expenses were lowered, and passive income increased, you moved closer and closer to not having to work for money. Sounds like a good plan to me!

How To Construct an Early Retirement Chart

1. Determine your total monthly expenses. For the next month (or use the previous month if you have all the records), track all expenses. This includes everything from the mortgage payment to the daily trips to the vending machine at work. When you have a good idea just how much money you spend each month, move to step 2.

2. Calculate your current monthly income. Begin to track your income from all forms of employment. That is, track money earned from your primary job as well as any self-employment or freelancing work.

2b. Calculate your currently passive monthly income. Add up your monthly passive income–that is, income that is not earned in step 2. This might include interest on deposits, stock dividends, book royalties, etc.

2. Construct an early retirement chart. This step can be as high-tech or low-tech as you prefer. I personally like to go low-tech here, opting for a giant poster-board available in the school supply sections of most stores. Using a large ruler, or similar straight edge, draw a large X and Y axis taking up most of the poster.

Divide the vertical axis by an interval that fits your situation. Most of us could probably work with a chart from $0 to $10,000 in increments of $100. Again, using your ruler and a pencil, lightly draw horizontal grid line across the chart at every $100 marker.

Along the lower axis, label the current month/year combination (i.e. “07/09″) and increment the months out as far as the size of the post poster allows, spacing about 1/2 inch in between months.

3. Plot your progress. Using three separate colors, begin to chart your monthly expenses, income and passive income. Chances are your chart will start off looking like mine did – my expenses exceeded my income each month, which explained why I was accumulating debt. However, over time we managed to lower our expenses and increase our income, which also increased the amount of passive income we were earning.

4. Find your intersection. After tracking passive income and expenses for a few months you will start to see a trend where these two segments will eventually meet. Your Money or Your Life refers to this as the cross-over point, because this is the point where your expenses are met by passive income. Theoretically, this is the point where you could quit working for income, assuming your expenses never increased.

One thing to keep in mind is that there are no guarantees with passive income. There are many variables that can affect this amount from month to month. Companies might slash dividends. Interest rates may rise and fall and affect your interest income. Royalty sales might drop significantly reducing the amount of payments to expect. For this reason, try to “lock in” as much of this income-producing money as possible by investing in things like long-term CDs, bonds and high-interest savings and money market accounts.

This post appeared in the Money Hacks Carnival: 84th Edition

Photo by thombo2

Most people assume to retire you must be a millionaire, literally. As if the magical number of one million guarantees a life of comfort for the rest of your days. Fortunately for the rest of us, that just is not true. There are plenty of people who retire on less than a million dollars, and live quite comfortably. Once you realize becoming a millionaire is not your end goal it makes the idea of an early retirement seem more within reach.

A Quick Look At Millionaires

Who are these millionaires we often read about-the ones that formed this perception that you have to be a millionaire to retire? Well, they come in various forms.

• Accidental millionaires.  These folks happened upon their millions by dumb luck or good fortune. Examples may include someone who won the lottery, or received a massive inheritance from a long-lost uncle, or even managed to cash out stock options while working at the same company for thirty years.
• Frugal Millionaires. This group spends well below their means, and banks the savings for a number of decades amassing a sizable amount of wealth in investment accounts. You wouldn’t know it by looking at them-they drive old cars, live in modest homes and wear everyday clothing.
• Self-employed Millionaires. Occasionally, this group includes those who have built and ran a successful enterprise for many years.  But often they cashed out early on, selling their business to a larger entity and banking the resulting millions.

Those are just a few examples of the various types of millionaires. Don’t want to spend too much time on their characteristics since we’ve already said that becoming a millionaire is not required to retire. Could you get by on $750,000? Many people get by on much less!

The Half-Millionaire

Let us assume that $500,000 is your ultimate savings goal. This is the point where you’d be willing to cash out and live off the interest and dividends. Would it be enough?

Well, you could expect about $20,000 a year from that half-million in interest, assuming a 4% return. If you kept “retirement” expenses down less than $1,600 a month you would be just fine. I know what you are thinking-who can live on $1,600 a month? Lots of people.

Imagine your future semi-retired life with no mortgage, no car payment, no debt of any kind. You have to pay property taxes and insurance on your home and car, and of course the customary expenses like utilities and food. Could you do it on $1,600? If so, you would never need to touch that original $500,000 balance.

If $1,600 sounds a bit to lean for your retirement budget, perhaps you could work part time, or do freelance work to supplement your income. With just a little effort you could easily take your income up to a more palatable $2,500 a month by working a few hours each week.

The point is, to cash out early on your career, you need to manage your own expectations regarding retirement. Not everyone has to become a millionaire to turn in a work badge. Retirement success is a function of reducing expenses (and debt) to a comfortable level and then building enough wealth to generate the income required to live in that same manner for a number of years. It really is that simple.

This post appeared in the Carnival of Pecuniary Delights: Welcome to Canada Edition.

Photo by Enkhtuvshin (Broke my camera )

Caught a great post over at Retirement: A Full-Time Job with the title, Thank God It’s Monday. Initially, I thought it was a typo – we all know the saying is, “Thank God it’s Friday!

Upon closer inspection I realized exactly what the author meant. Like her, I dread Monday mornings to the point that I literally get depressed on Sunday evenings. If you were to track my energy levels, and my mood, from Friday night to Sunday night it would show a steady decline leading up to Monday morning. I hope to change that before too long!

My weekends seem to get shorter and shorter, and as my kids grow older I find myself trying to cram more and more into them. As a result, I find myself exhausted on Sunday evenings and joke to the family that I have to go back to work to rest. But that’s just it – I don’t rest. I get no downtime, no time to pursue other things that are important to me. My family time suffers, and after keeping this schedule for weeks on end, burnout is inevitable.

I can’t wait until I reach semi-retirement and feel just as enthused about Monday mornings as I do about Friday mornings. Until then, here are a few strategies I use to reduce the Sunday night dread:

• Find full-time work doing something you truly love. I know it sounds cliche, but it really works. The times when I have felt passionate about my Monday-Friday mission have been some of the happiest “work” memories I have.
• Find your passion outside the office. A few years ago I was really into coaching youth sports. Probably because I used to want to be a high school coach. But I took a different path in my career, so I made time to volunteer as a coach for my kids’ sports teams.
• Ask your boss for a flexible schedule. One of my favorite books, The 4-Hour Workweek, advocates this strategy as a way to start slowly unplugging from the office. It might be as simple as asking to work half-days from home on Fridays to beat the commute, or going to a 9/80 work shedule where you are off every other Friday.

Photo by biofriendly

A lot of people walk away from successful careers for noble reasons. Perhaps they want to pursue volunteer activities, or do mission work, or go back to school to change careers. I have some of those same ideas in mind for when I step away, but I would be lying if I did not also mention one of my major motivations is just to leave the corporate beaurocracy behind.

The movie Office Space does a great job of poking fun at the corporate wold, and I think the enviornment depicted in the film is fairly representative of most large companies (at least the ones I’ve worked for). During one scene the main character, Peter Gibbons, tells his friends, ” Human beings were not meant to sit in little cubicles staring at computer screens all day, filling out useless forms and listening to eight different bosses drone on about about mission statements.” well said. For those who don’t remember the movie, or have never seen it, here’s a look at the trailer.

Somwhere between my noble pursuits, and an irreverant attitude towards corporate life, lies the real answer to the question, what’s my motivation? My real motivation can be summed up in one word: freedom. I want the freedom to do what I want to do with my life without having to ask for time off to do it. Without having to worry about earning enough money to cover it. To me, that is the ultimate freedom.

When I was young I knew a guy who was friends with my high school football coach. He had “retired” at 45, and spent part of his summers every year helping out with the team. He mowed the grass on the practice fields one evening a week, and opened up the gym for summer workouts when the coach couldn’t make it.

One day I asked him if he worked and he told me no. He said he had been retired for nearly twenty years (he was in his sixties now). “Best decision I ever made. Get to spend time with my grandkids and you guys. Wife and I do a little traveling someplace warm in the winter.” If this guy was a millionaire it certainly wasn’t obvious. He drove an old truck, and I never saw him in anything other than sweatpants and t-shirts.

Someone later told me that he was in fact a millionaire. He and his wife had saved nearly everything they earned for two decades and then both walked away from their jobs in their mid-forties to care for their parents, and be more involved with their grandkids. Even at 17, I thought that was exactly who I wanted to be like in thirty years. Too bad I squandered so many opportunities during college, and immediatedly after. I’m getting a much later start than “Coach” did, but I’ll get there.

Photo by I’ll Never Grow Up