Jonathan B. Smith thought he would be retired by his 40s. Instead, the longtime entrepreneur is just now opening a retirement savings account.
Smith, owner of the Chief Optimizer business strategy firm in Arlington, Va., says he has always valued saving over spending, but he didn’t have a process in place. Now, with the proceeds of a favorable investment, he’s setting up an individual 401(k), which appealed to him because of its high contribution limits. But, he says, “even if I fully fund the 401(k), it’s not enough to last me through retirement.”
Like Smith, many small business owners haven’t established a retirement savings plan, despite the tax benefits that such plans provide. Only 36 percent of small business owners have an IRA, according to a 2010 analysis by the U.S. Small Business Administration, and only one-third of them contribute to it. To put that in context, consider that about 66 percent of American adults have some retirement savings, according to a report released in August by the Federal Reserve Board.
The challenge for small business owners is that they are solely responsible for their own benefits and savings, says Nancy Skeans, managing director for personal financial services at Schneider Downs Wealth Management Advisors in Pittsburgh, Pennsylvania.
“In your own business, you have to think about things like disability insurance and life insurance for yourself, too,” Skeans says. “People may not want to spend money because of cash flow when they’re starting out. But at some point you have to have an exit strategy.”
Your business is not your retirement
The biggest mistake business owners can make is to assume they will sell the business to fund their retirement, with no other savings, says David L. Perkins Jr., managing director of Acquisition Advisors in Tulsa, Okla. That strategy also misses out on the tax advantages that retirement plans can provide in the ensuing years.
“The sad cases are in smaller businesses when they’re making $50,000 to $200,000 a year, and they’ve not saved outside of their business,” Perkins says. “They’ve kicked the can down the road and there’s no way to make up that savings.”
Skeans says often a company has lost more value than the owner realizes, because he or she hasn’t continued to build the business. Even a strong client base will eventually decline if it stops growing, she says. “You’ve put in so much money and time,” Skeans says. “But the real business that’s thriving, the one that someone might pay you one or two times revenue for, is slowly disappearing.”
Ask for advice
Dentist Matt Lawyer and his wife, Kendra, plan to sell Carothers Parkway General Dentistry in Franklin, Tenn., as part of their retirement strategy. But they’re also working now with their financial advisor to establish a retirement savings plan to supplement the proceeds from the sale. Up until this year, the Lawyers’ only investments were tax-deferred college savings for their children.
“We’ve just started the process of planning for retirement, which will hopefully be in the next 15 or 20 years,” Kendra says. “He doesn’t really want to be working until he’s 75.”
Kendra, who handles the financial side of the practice, says they’ve spent the first 10 years growing their patient base and paying off a business loan. Now, they plan to reallocate the money that they once used for loan repayments to their retirement savings.
Options for small business owners and the self-employed
Several tax-deferred retirement plans are available to small businesses and sole proprietors and are outlined below. Contributions to employee plans are considered deductible business expenses as well. And, Skeans adds, business owners can change plans as the company grows or changes.
(See www.irs.gov/retirement for complete comparisons and up-to-date contribution limits. The U.S. Department of Labor also produces a guide to choosing a retirement solution for your small business.)
IRA: An Individual Retirement Account is the leanest option for the self-employed, Skeans says, with the fewest tax benefits and lowest contribution limits -- $5,500 for the 2014 tax year, or $6,500 if you’re age 50 or older by the end of the year. But, she cautions, “if you just settle on an IRA because you don’t want to be bothered with the rules governing contributions to other kinds of accounts, you really can lose the tax benefits that go along with putting money into these plans.”
SIMPLE IRA: Business owners with 100 or fewer employees can offer a Savings Incentive Match Plan for Employees, with low setup and administrative costs. The employer and employee can contribute up to $12,000 each in 2014. (Workers over 50 are eligible to make a $2,500 catch-up contribution.) Employers are required to contribute to their employees’ plans, between one percent and three percent of total pay.
SEP Plan: The Simplified Employee Pension appeals to entrepreneurs who don’t have employees because of its high contribution limits -- 25 percent of compensation, up to $52,000 a year – and its low setup cost. Only the employer contributes; if you have employees, you must contribute to their accounts at the same percentage as your own. This could hamper your ability to make your own maximum contribution; however, contributions don’t have to be made every year.
Individual 401(k): A 401(k) plan is a more expensive option because you must pay a plan administrator. But you can double up contributions as both employee and employer. Here’s how: you can make employee contributions up to $17,500 this year ($23,000 for those 50 and up). Add to it your employer contribution, which can equal up to 20 percent of your net earnings. The combined contribution can top out at $52,000 in 2014, plus a $5,500 catch-up contribution for those 50 and up.
“Even if you just start with small amounts, it helps you from a tax standpoint, and you get the benefit of compounding,” Skeans says.