GPS for retirementville
Every business owner knows that running a business is more than a full-time job. Depending on the size and structure of the business, an owner may serve as everything from salesperson to production manager, to office manager, to client services representative and then some. With all of that on their plates, it’s no wonder successful owners soon learn setting priorities is essential to success. So many business owners get caught up in the necessity of maintaining the profitability of their business, especially in today’s economic climate, that they tend to overlook the need to plan for their eventual exit from the business.
Sometimes the reality of the situation doesn’t hit home in until they are ready to consider retirement and, for the first time, finally realize that neglecting the situation may have changed the path of the future. The once enticing prospect of a successful and relaxing retirement spent on a beach or with family suddenly crashes into the reality of time lost, and goals suddenly seem unreachable. These same people never saw the train coming or realized it was moving too fast, and now they have a hard time getting out of the way.
There is a retirement company that had a commercial depicting a 500 lb. gorilla sitting in the corner of the room being ignored by everyone. There is no better analogy for retirement funding. We know the problem looms but put it off because there are more pressing daily issues to tackle, and we believe there is plenty of time to deal with it later. Sooner than later, there is a lot of catch up to do. In order to get started early enough to meet retirement goals, business owners need to bring the same level of enthusiasm to planning for retirement as they do to running the daily company operations. The first step is to anticipate and understand future needs. Most important, make a commitment to investing in retirement.
Convince yourself that retirement is as important as running the business. Ultimately, the priority being served by keeping your business healthy and successful is YOU. Of course, there are many important questions to consider, such as: When do I want to retire? How will I fund my retirement, and how much money will I need given my lifestyle? Will I have to change my lifestyle? Will I have the ability to sell my business or, do I want to pass it along to my family? Asking and answering these questions will help set those essential retirement goals.
For most owners, the key concern is having enough money to maintain a comfortable lifestyle after retirement. The question then becomes, “How do I get there?” Fortunately, there are a lot of options for funding retirement. Unfortunately, because of the variety in retirement vehicles, many business owners feel overwhelmed and continue to put off making plans for the future. Time is an essential factor in any investment strategy, and any owner who feels “lost” when it comes to planning for retirement should seek expert advice. This involves sitting down with a certified financial planner and/or retirement specialist who can do an analysis of long-term goals and what it will take to get there. An honest approach must consider whether the goal is even realistic.
A financial specialist can also help business owners consider important factors such as company size and profitability, as well as whether the owner has a desire to share retirement benefits with employees. The evaluation of these factors will allow a qualified retirement specialist to provide a recommendation that is best suited for the business and its owners.
How do I choose the best plan for me?
Planning for retirement depends on an individual’s goals and the size, structure and profitability of the business. Consequently, there is no single best retirement plan. It is not a “one-size-fits-all” proposition. Therefore, the business owner’s goal should be to discuss the situation with a financial advisor who can help determine the plan or plans that best fits the owner’s and the company’s needs. Among the factors an employer should take into account are:
- What is the maximum amount I can afford to invest?
- What setup or administrative difficulties exist for different plan types?
- How expensive will the plan be to administer?
- What are the tax advantages (or disadvantages) of various plans?
- What level of commitment am I willing to make to my employees and their retirement?
After careful consideration of these issues with a financial consultant, an individual can set out to explore specific options.
Is the business saleable?
One common exit strategy is for business owners to sell their business and use the resulting revenue for retirement. In fact, there can be some very tax-advantaged ways to structure the buy-out to significantly reduce the tax costs and even spread them out over time. On the surface, this might seem like a logical solution; however, it can bring with it a host of problems. In essence, owners who adopt this strategy are risking the possibility of discovering that their business is not as saleable as they thought it was, or that the business is not worth enough to adequately fund their retirement. Of course, these are not the only risks. There is also the possibility that the company could fail entirely. Additionally, another inherent risk is that business owners also have a tendency to see their business (and their sweat equity) as being worth far more than an outsider might. This can leave the business owners with a considerable gap to fill when their business doesn’t realize as much on the open market as they would have thought.
In other cases, owners may not be able to count on a revenue stream from the sale of their business. Very often in closelyheld companies, the owners wish to pass the business along to their children, and in some cases, often at far less than fair market value.
When business owners seek to pass their business on to their children, another common problem that occurs is they want to continue to draw income from the business, even after they have long-since stopped working in it. Unfortunately, family members don’t often see eye-to-eye regarding this expectation, and conflicts can arise. Of course, depending on the cash flow in the business, this may not even be possible. Generally speaking, it may often take hiring a new employee to help replace the work formerly done by the retiring business owner, and so the cash flow that was once previously available may now be significantly depleted.
In family situations like those mentioned, business owners need to examine other options to fund retirement. Such options usually involve tax-deferred plans, such as 401(k)s, IRAs and SEPs.
Many financial advisors see tax-deferred vehicles as the cornerstone of a sound retirement strategy. There are two main reasons for this. The first is the consideration of the time-value of money. Quite simply, this means that by using a tax-deferred investment, an individual is able to invest money that would have otherwise been paid to the government in taxes. In other words, instead of investing $70 and paying $30 in income tax (assuming a 30 percent tax bracket), an individual is able to invest the entire $100. This amount will then generate a higher investment return and thus, grow faster. When this effect is extrapolated over a period of years, the tax-deferred investment vehicle becomes an incredibly powerful tool.
The second primary consideration for a tax-deferred investment involves the tax deferral itself; which, in essence, refers to the likelihood that the investment will ultimately be subjected to tax at lower tax rates. The reason for this argument is that at retirement, most individuals are not at their highest earning capacity. Consequently, by deferring taxes until retirement an individual will, in nearly all cases, be paying taxes on a reduced income and be in a lower tax bracket, thereby netting more after-tax dollars than if the money was taken into income when in a higher tax bracket.
For example, an individual who—during his or her highest earning capacity—is making $200,000 per year, may be in the 33 percent tax bracket. This means that any additional income that is not deferred to a future year would be subjected to tax at a 33 percent tax rate (assuming just the federal tax brackets and that the individual is married). At retirement, this same individual is more likely to be on a fixed income, with social security and other benefits. If we assume, for the sake of argument, that this individual’s income drops to $60,000 after retirement (which is not a stretch), that same person would now be in the 15 percent tax bracket. This is a change of 18 percent in his federal tax rate. Obviously in this example, $100,000 of income deferred to retirement would save $18,000 in taxes in the year of withdrawal.
Most consultants consider 401(k) plans to be an extremely effective retirement savings tool. Such plans offer individuals the ability to set aside $15,500 a year tax free and an additional $5,000 in “catch-up” contributions for those 50 or older. Unfortunately, small business owners tend to underutilize these plans, often due to misperceptions. For example, small business owners may believe they do not have enough employees to make these plans worthwhile or that they cannot afford a company match. In reality, an owner does not need to have any employees to participate in a 401(k) plan. As a sole proprietor, an individual can receive 401(k) tax benefits through “individual 401(k)s.” In 2008, the contribution limits for these plans are a generous $46,000 per year. For those with just a few employees, even as few as one, the Internal Revenue Service allows for a variety of other 401(k) plans. In addition, there is no mandatory company match. The only requirement is that a 401(k) plan, if offered, be made available to all of a business’s employees.
IRAs—traditional and Roth
Both traditional and Roth IRAs are investment vehicles that provide for the tax-free accumulation of retirement income. In a traditional IRA, an individual is eligible to begin withdrawing his or her funds at age 59 1/2. The investor may, however, wait until age 70 1/2 to begin taking distributions. An advantage of the IRA is that it is simple to set up. A disadvantage, however, is that the contribution limits are quite low (currently only $5,000 per year or $6,000 if the investor is 50 or older). For most individuals, this is far too little to fund a comfortable retirement.
While similar to the traditional formula in many ways, the Roth IRA differs significantly in that taxes are paid on income before the money is deposited into the Roth. Then, the money deposited in the Roth grows tax free and, when funds are withdrawn from the Roth, no taxes are due. Since none of the investment growth is ever subject to income tax, the net investment return is increased significantly.
SEP (Simplified Employee Pension) plans
The SEP plan is popular among small to medium-size businesses. In a SEP, the employer is solely responsible for contributing to IRA plans for his or her employees. For this reason, the SEP is an attractive benefit that allows smaller companies to compete with larger firms for the most desirable workers. Another advantage of the SEP is that it is a simple plan to administer. In a 401(k) plan, for example, there are many administrative requirements and complexities that add to the cost. For example, administrators of these types of plans may need to set up a separate trust, which obviously increases costs. The SEP, on the other hand, does not require a separate trust and is therefore often a good choice for a sole proprietorship or partnership.
Other retirement options
In addition to traditional options, financial consultants have been developing more innovative plans in recent years. These plans often focus on owners who feel that they have discharged their obligations to their employees and are concerned primarily with their own retirement. They are also often for employers who are maxing out the benefits they pay to their qualified plans (a few of which are noted above) and are looking to do more. Such plans may be known as “non-qualified” plans, which means they are not subject to some of the constraints of ERISA (Employee Retirement Income and Security Act) and its regulations, which govern “qualified” plans, such as 401(k) plans, pension plans and the like. Because these plans are “non-qualified,” employers can offer themselves (and upper management, if they so choose) retirement options that they do not have to make available to “rank-and-file” employees.
An example would be a tax-deductible deferred compensation plan. While deferred compensation plans have been around for quite sometime, the concept of “tax-deductible” deferred compensation is a more recent development. The basic mechanism behind this type of plan is that it requires participation in a Professional Employer Organization, which performs certain services for the employer and acts as a co-employer of the employee. In essence, this can allow upper management to take advantage of a sort of super-charged 401(k) plan. Large contributions can be made (often hundreds of thousands of dollars, if desired) with income tax deferred to later years.
Another advanced approach to retirement planning may involve the use of “phantom stock.” Say an employer wants to retain a key employee but does not want to part with corporate ownership. On the other hand, he or she wants upper management to feel it has a powerful interest in growing the company by providing a reward for that growth. In this case, the owner can set up an arrangement whereby the valued employee will not receive actual stock but will receive financial benefits that mirror the company’s performance. This can provide excellent benefits to key personnel, and such plans are relatively inexpensive to set up.
Another common but more advanced strategy may be a defined benefit pension plan. A specific advantage this type of plan has over many other plans is that it allows business owners who have not put away much to put away a much more significant amount in a short period of time. These plans allow an individual who earns $150,000 a year, for example, to invest as much as $80,000 of that income toward his or her retirement. Because defined benefit pension plans make it possible for owners to achieve greater growth in a shorter period of time, they have become much more popular with small and medium-size businesses.
Make retirement a priority
Clearly, a variety of retirement savings options are available, but these options, whether traditional or more innovative, will do little good for those who do not use them. Unfortunately, any financial consultant can cite numerous cases of clients who have not given retirement planning the attention it deserves. To some extent, it is understandable. As noted previously, small business owners face numerous challenges each day in keeping their businesses profitable. Nonetheless, effective retirement planning and accumulating enough money to enjoy a comfortable retirement depend heavily on commitment, making the right investment decisions and giving one’s money time to grow. Unfortunately, owners who neglect these realities may find they will never be able to retire or they will fail to enjoy retirement to its fullest. To overcome this, small business owners need to make themselves a priority, and bring the same enthusiasm and commitment to retirement planning that they bring to managing their businesses. Even if some time has passed, it is possible to do some catching up with the right retirement vehicles. Just remember that although the decisions can seem difficult, the answers can become much clearer with the aid of a qualified retirement specialist; however, you must commit to taking the first step.