If you’re a small business owner, you know the lines between business and personal can quickly become blurred. The business can become your priority, your life. And in many cases, it can also become your retirement savings plan. It's not uncommon to forego developing a formal retirement savings plan and assume that when the time comes, the sale of the business and its assets will fund your retirement.
Banking on the sale of a business to fund retirement is an approach that is—on the surface—understandable. You pour your heart and soul into the business. You’re likely to put every dollar of profit back into the business to ensure that it succeeds. Particularly in the early years, survival is the number one priority, which means that funding a qualified retirement plan such as a 401(k) often takes a back seat.
That strategy, however, is not without considerable risk. What happens if the business fails or you become disabled? What if there is no buyer for the business or if the sale fails to generate enough revenue to support your expectations for retirement? Because there is such inherent risk, the successful conversion of business assets into retirement income is something you must plan for well in advance. It doesn't magically happen at age 65, and it has to be part of a broader strategy to prepare for the unexpected, retain and reward key employees, support personal goals and transition the business in the most cost-effective and tax-effective method possible.
The complexities associated with transitioning from ownership to retirement are compounded by the fact that it's often difficult to separate business from personal when making critical decisions. There's tremendous emotional attachment to the business, and that can, at times, cloud judgment. For example, small business owners often think the business is more valuable than what it's worth. Or they may fail to consider that they're likely to live 30 or more years in retirement when calculating their retirement income needs. Unless these issues are addressed early in the life cycle of a small business, they become difficult, impossible or very expensive to deal with later on.
To help ensure the successful transition from ownership to retirement, you should—at the very least—take these three steps:
- 1. Develop a Business Succession Strategy-Identify an individual or business that may be a logical successor to take over the business. Then, partner with an expert in estate, business and retirement planning to obtain a value for the business; develop a buy-sell agreement; and establish a mechanism to fund the future transition through earnings from the business, bank loans, nonqualified annuities or the cash value of life insurance policies.
- 2. Establish a Qualified Retirement Plan-Don't underestimate the value of establishing a qualified retirement plan, such as a 401(k). With these plans, there are a lot of rules, complexities, liabilities, responsibilities, costs and risks, but the benefits will almost always outweigh the disadvantages. Many business owners assume that the plan will be ‘too expensive’ to establish because they would have to include their employees. That’s why a realistic discussion of plan types and costs is essential. Contributions made to qualified retirement plans are tax deductible by the employer and are a great way to move cash flow out of the business in a tax-efficient way, allowing for diversification of assets away from the business. Plus, qualified retirement plans can be instrumental in helping small business owners attract, retain, reward and motivate talented employees who can help to grow the business.
- 3. Consider Setting Up a Nonqualified Retirement Plan to Accumulate Additional Dollars for Retirement-Nonqualified retirement plans are designed to offer valued, highly compensated employees a way to accumulate additional dollars for retirement beyond the contribution limits of a qualified plan. Here are three of the most common types of nonqualified retirement plans:
- A Supplemental Executive Retirement Plan is a form of “deferred compensation,” but the money contributed comes from the employer and not the employee.
- An Executive Bonus Plan provides an employee with additional income that can be used to purchase insurance, annuity or investment products.
- A Deferral Plan allows an employee to defer some of his or her income, earn a return on that money and receive it at a later date. The benefit of this type of plan is that an employee can defer paying taxes on this income while saving more money for retirement.
By taking these three steps, small business owners will be well on their way to ensuring the successful transition from running a business to enjoying the rewards of hard work and living the life they envision in retirement.