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The company may be your largest asset if you are self-employed or own a small business. It is also likely that maintaining your business endeavor takes much of your time, so focusing on retirement planning can be difficult—even if you plan to retire soon.
Yet, you must understand the retirement income strategies available to you so that you can begin—and continue—funding your future incoming cash flow plan.
As a small business owner or a self-employed individual, you could face several common financial and retirement challenges not faced by W-2 employees. One of the biggest of these can be using a significant amount of your assets to start and grow your company.
Based on the findings from a 2017 study by Manta Trends, some of the most common reasons small business owners do not have a retirement savings plan in place include the following:
Not generating enough profit to save for retirement
This same study also determined that approximately 34% of small business owners have no retirement savings plans at all.
Given that small business owners and self-employed individuals have personal savings, needs, and objectives, they can face the same risks that others have—but there can also be some additional challenges.
For example, many newer businesses must attain a customer base, and depending on the products or services offered, this can take a considerable amount of time. Plus, there are no guarantees that a business will ever get off the ground from a profitability standpoint.
There can also be some unexpected challenges—even for successful businesses. For instance, during the COVID-19 pandemic, many companies were forced to scale back or even close permanently, given the social distancing requirements and other measures that were put in place.
Further, some of the common financial and retirement planning challenges that small business owners and self-employed individuals share with other investors can include the following:
– Volatile Stock Market
– Low Interest Rates
– Inflation
– Sequence / Order of Returns
– Healthcare Costs
– Potential Long-Term Care Expenses
– Longevity / Living “Too Long”
If you lose:
If you lose:
Even though investing in the stock market can provide an opportunity to beat inflation and generate significant growth, it can also be risky. For instance, many investors lost their life savings during the recession of 2008 and the more recent COVID-19 pandemic and corresponding stock market fall in March 2020.
Even if you don’t plan to retire for many years, there is no guarantee that your portfolio will ever return to its previous value—further, the larger the loss, the higher the future return to break even.
For over a decade, the United States has been in an environment with a low interest rate. But, while this can equate to lower interest rates on mortgages and other loans, it also means that investors are generating meager returns on fixed financial vehicles like bonds and CDs (certificates of deposit).
This, in turn, can hurt future retirement income, as well as your future purchasing power. For example, if you place $1 million into a bond generating 2% interest, your income from that bond would be just $20,000 per year.
Would you be able to live comfortably on that amount in retirement?
Reinvestment risk can also be a concern when it comes to interest rates. This refers to the risk that the future return will be even lower than the current one. So, for instance, if the bond generating 2% interest matures in the future—and rates have fallen even further—you could reinvest your money at 1% and cut the amount of income you generate in half.
Inflation refers to the “general increase in prices and the fall in the purchasing value of money.” Over time, the price of goods and services will typically go up. In some cases, the price increase is gradual, so it can be challenging to see just how drastic its impact truly is. You may have had to raise the price of the goods and/or services offered through your business.
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Due to inflation, more money is required to purchase the same amount of goods and services. So, income will typically have to increase over time to maintain one’s lifestyle. With that in mind, it is essential to consider inflation in your retirement income plan.
Another key retirement risk that self-employed individuals and small business owners (as well as individuals) can face is the sequence or order of returns. While this risk is not often highlighted, not planning ahead for it can have a negative impact on how long your assets and income last.
This risk has to do with when returns are received. In this case, even if two investors attain the same average return over time, if one is hit with a negative return before the other investor attains the loss, it could speed up the time for the first investor to run out of money.
For example, if Investor #1 and Investor #2 both average a 7% return over a three-year period, then they both plan to access 9% from their portfolios each year as retirement income. But even though both investors received annual returns of 7%, 27%, and -13%, they were attained at different times.
Therefore, even though all other factors were equal because Investor #1 obtained a negative 13% return a year earlier than Investor #2 did, his portfolio was depleted six years earlier than the portfolio of Investor #2. Therefore, paying attention to the received returns and when they are received is essential.
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A healthcare situation can significantly impact someone who is self-employed or a small business owner. Depending on what type of planning you have done, it is possible that you could go without income for some time when you are unable to work.
Healthcare can account for a considerable amount of your expenses before and after you retire. If you (and your spouse, if applicable) qualify for Medicare, this program still requires you to pay expenses like deductibles, copayments, and/or coinsurance.
Even with Medicare and/or other health insurance coverage, it is estimated that a 65-year-old couple who retired in 2021 can expect to spend approximately $300,000 in out-of-pocket healthcare expenses—and this does not include the cost of long-term care needs. So, it is essential to plan ahead for these costs.
Another need that small business owners should consider is the potential for long-term care services—as a care recipient and/or a care provider to a parent or other loved one. U.S. government statistics show that 70% of people who are age 65 and older will require at least some form of long-term care, and 50% will need extensive services.
The cost of long-term care can be astronomical, though, and it could potentially wipe out one’s life savings within a short period. According to the Genworth Cost of Care Survey, the average monthly cost in 2020 of a semi-private room in a skilled nursing home facility was over $7,750, and one month in a private room averaged more than $8,820.
Even homemaker and home health aide services can be costly, at approximately $4,500 monthly. So, even though nobody likes talking about this type of situation, financially planning ahead for it is crucial.
With a longer life expectancy, people are spending more time in retirement. So, income must be stretched out even further. According to the Social Security Administration, a man turning age 65 on April 1, 2020, can expect to live, on average, until age 84. On average, a woman turning 65 on April 1, 2020, can expect to live until age 86.5. And these are just averages.
Approximately one out of every three 65-year-olds in 2020 will live to at least age 90, and about one in seven will live at least to age 95. But, while living longer can undoubtedly allow you to spend more time with your loved ones, it also means that your retirement income needs will be stretched out further.
Small business owners are typically responsible for planning their own retirement. Unlike being an employee of a large company, though—where a 401(k) or other savings plan may already be set up—small business owners need to do this planning on their own.
The good news is that there are a variety of plans available to self-employed individuals for retirement savings. These can include the following.
SEP IRAs, which refer to Simplified Employee Pension Individual Retirement Accounts, can provide self-employed individuals and small business owners a viable way to grow savings on a tax-advantaged basis for the future. These plans are relatively easy to establish and can typically be opened through a bank, brokerage, or other financial institution. With a SEP IRA account, you can contribute much more than you can with an individual IRA account. For instance, if you are self-employed, you may put in up to 25% of your net earnings from self-employment (not including contributions for yourself), up to $69,000, for the tax year 2024. The contributions to a SEP plan go in on a pre-tax basis, and the funds in the account grow tax-deferred, meaning there is no tax due on the growth until the withdrawal time. You must start taking distributions from a SEP plan at age 72 based on the required minimum distribution (RMD) rules. Because none of the money in a SEP IRA has been subject to income taxation yet, the withdrawals will typically be 100% taxable at your then-current income tax rate.
Another type of retirement plan for small business owners and self-employed individuals is the SIMPLE IRA. The acronym SIMPLE stands for Savings Incentive Match Plan for Employees. You can contribute all of your self-employment earnings into a SIMPLE IRA plan, up to a maximum of $16,000 (in 2024) if you are age 49 or younger, or $19,500 if you are age 50 or older. In addition, the employer can add an additional 2% fixed contribution or a 3% matching contribution to the account. The earnings in a SIMPLE IRA are also tax-deferred until withdrawal. These plans are also subject to the required minimum distribution (RMD) of IRS rules when the participant turns 72.
You can open and contribute to a Solo 401(k) plan as a self-employed individual. These plans are specifically for those business owners with no employees (other than their spouse). Solo 401(k) plans work similarly to an employer-sponsored 401(k) in that you can make pre-tax contributions to a traditional plan, and the earnings can grow tax-deferred. Withdrawals from a traditional Solo 401(k) are 100% taxable as income. There is also a Roth option with Solo 401(k) plans. With a Roth Solo 401(k), contributions are made with after-tax funds, and the withdrawals come out tax-free, regardless of your future income tax rates. This could allow you to obtain a larger amount of net spendable retirement income in the future. You can contribute 25% of your net self-employment income as a sole proprietor or single-member LLC. This equates to your company’s net profit minus half of your self-employment tax and also minus any of the contributions you made for yourself into the plan. Contributions may be made up to $69,000 (in 2024) if you are age 49 or younger, plus an additional $7,500 if you are 50 or over. The traditional Solo 401(k) plan is subject to the RMD rules of the IRS, while the Roth Solo 401(k) plan is not.
In addition to your business-related retirement plan, you may also be able to take advantage of a personal IRA (Individual Retirement Account). IRA accounts can be traditional or Roth—and, depending on your income, you may be eligible to have both an individual and a Roth IRA account.
Traditional IRA
Contributions that go into a traditional IRA account are typically pre-tax. So, the amount of money that you contribute to a traditional IRA account can reduce the amount of taxable income you have. The earnings in a traditional IRA grow on a tax-deferred basis. Because of that, 100% of the distributions from a traditional IRA will usually be fully taxable when withdrawn.
Similar to a traditional SEP and SIMPLE plan, traditional IRA accounts are subject to the RMD rules that the IRS sets forth. This means you must begin taking at least a certain amount out after reaching age 72. Otherwise, you could face a penalty of 50% of the shortfall amount. Annual maximum contributions to a traditional IRA are $7,000 if you are age 49 and younger and $8,000 (in 2024) if you are age 50 or older.
Roth IRA Account
Roth IRA accounts can offer individuals some nice tax incentives. For instance, even though you are not allowed to deduct the amount of a Roth IRA contribution on your income tax return, the earnings in a Roth IRA account are tax-free, as are the withdrawals.
The same annual maximum contribution limits on traditional IRA accounts also apply to the Roth IRA. If an investor has both a traditional and a Roth IRA account, the contribution limit is cumulative, meaning that deposits may be made to one or both accounts. Still, the total dollar amount may not exceed the annual total limit.
Also, income limits are in place for Roth IRA accounts. So, investors—including small business owners and self-employed individuals—who earn “too much” in annual compensation may not be eligible to open a Roth IRA. However, if you fall into this category, some viable strategies may still be available to you for participating in this type of retirement account.
In addition to the different types of accounts that may be available to help you save for retirement, another financial tool can ensure that you receive an income for a number of years or even for the remainder of your lifetime—no matter how long that may be. That is with an annuity.
Annuities can offer other benefits, too. For example, the funds that accumulate in an annuity (before they are converted into an income stream) are allowed to grow tax-deferred, meaning there is no tax due on the gain until the withdrawal time. This can help the account value accumulate exponentially—especially over a more extended period.
In addition, the tax-advantaged nature of annuities can also allow for an additional source of tax-advantaged savings—even if you have already “maxed out” the allowable annual contributions to an IRA, SEP IRA, and/or other employer-sponsored or small business owner retirement plan.
As a small business owner, an annuity could be an ideal retirement savings solution, as many deferred annuities will allow you to make smaller contributions over time. That way, even in “lean” times for your business, you can still be assured that you have a retirement income-generating vehicle available for the future.
If you wish to pass your company on to a loved one or other individual(s), a business succession plan can help you create and implement a strategy that works for your specific objectives. It can also detail how the funding may take place.
For instance, many business owners and partners use life insurance as a funding mechanism, so other existing partners or owners may purchase their share of the company upon death. Alternatively, these funds could instead be used to keep the business afloat while a buyer is sought.
A “buy-sell agreement” is a strategy that business owners or partners often use regarding the company’s succession upon losing a key individual. Typically, this type of agreement stipulates how a deceased or disabled owner or partner’s shares will be distributed.
In this case, the business owners or partners will purchase life insurance policies against each other. When one passes away, the death benefit proceeds can be used to “buy out” their company share by the remaining owners or partners.
As a small business owner, you must have the right retirement plan in place. To ensure that you have all of the pieces in place, it is recommended that you work with a financial professional who is well-versed in creating, implementing, and maintaining personal and employer-sponsored accounts.
If you would like to schedule a time to talk with a retirement specialist, feel free to contact us directly at <phone number> or email us at <email address>. We look forward to helping you protect your financial security.
If you are self-employed or the owner of a small business, there are several options available that could be a good fit for you as you plan for retirement, as well as the succession or sale of your company.
But before you open or fund any type of retirement account—either for business or personal objectives—it is recommended that you first discuss your goals, time frame, and risk tolerance with a retirement planning specialist who is well-versed in the needs of business owners.
So, if you would like to schedule a time for a no-cost, no-obligation consultation with an expert in this area, feel free to contact us directly by calling <phone number> or sending an email at <email address>. We look forward to helping you.
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