The path to retirement

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Business owners often have a conception of retirement far different than the rest of America. While the 9-to-5ers may have a definitive finish line in mind — age 65, 25 years of punching the clock, etc. — entrepreneurs have two distinct advantages.

First, most business owners enjoy their work, or else they would have never mastered their craft and have already gone out of business. Even if the work becomes boring, business owners have the autonomy to alter their product/service to meet new fads, consumer desires, competition, or shift toward segments more fitting for the company. Second, as the golden years approach, the boss can retain the right to work within a comfortable capacity. He or she may shift to part-time, of counsel, or as a consultant to the heir apparent. This flexibility can delay retirement further than the average employee who lacks such flexibility.

However, according to the Center for Retirement Research, one-third of retirees leave work sooner than expected. Two of the top three reasons for early dismissal include health issues and familial issues — causes business owners are not immune to. With the need for retirement planning ever-present, let’s walk through the options based on each phase of the business cycle.

Startups

Every business starts with an idea, usually in the format of a sole proprietorship or partnership. At this stage it may be premature to hire employees as the business owner acts as a jack of all trades. The first and perhaps easiest option would be to open a Traditional IRA (Individual Retirement Account). In 2020, account owners can contribute $6,000 to their IRA, and $7,000 if over the age of 50. These contributions can be fully tax-deductible.

The business owner can avoid fees, testing and administration constraints found in larger plans that they’re not yet ready to handle. If he or she is looking for tax-free growth, the owner can contribute the same amounts to a Roth IRA if Adjusted Gross Income (AGI) is below $124,000 filing single and below $196,000 filing jointly.

Early growth

Once the business is up and running, owners may be looking for ways to defer even more compensation. At this point, he or she may consider a SEP IRA (Simplified Employee Pension). This works similarly to the Traditional IRA mentioned above, except the contribution limits go up to $57,000, or 20 percent of the net adjusted self-employment income, whichever is lower. Beware, the owner must make contributions to all eligible employees’ SEP IRA’s as an equal percentage of salary; employees are also immediately 100 percent vested in all contributions. The business owner might always stick with this plan if there are no employees or a small staff with low compensation (think of a consultant or contractor).

A similar company with more employees, but still fewer than 100, might consider a SIMPLE IRA (Savings Incentive Match Plan for Employees). Here the employer must contribute a matching contribution up to 3 percent of compensation, or a nonelective 2 percent for each eligible employee. Unlike the SEP, employees are allowed to contribute to this plan. The 2020 limits are $13,500 and $16,500 if over age 50. Both options are relatively inexpensive to set up and easily administered.

Mature companies

The larger company will likely consider a 401(k). These plans allow employees to defer up to $19,500 in 2020, and $26,000 if over age 50. An employer is not locked in to certain contributions every year.
However, anti-discrimination testing is present in the form of Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. Much of this testing can be circumvented if the employer sets up a Safe Harbor 401(k), which contains either a matching provision or a non-elective contribution. Including a Profit-Sharing Plan may allow the deferral up to the 2020 maximum under one company of $57,000, or $63,500 if over age 50.

These plans are more complex and costly than those mentioned in the first two phases, as startup costs, annual maintenance, and fund management fees are necessary.

Alternatives

The plans addressed thus far are specific to retirement, offering certain tax deductions and tax-deferred growth advantages (or post-tax contributions with potential tax-free growth in the case of the Roth option), but with rules and restrictions governed by the Internal Revenue Code, such as liquidity issues in premature distribution penalties before age 59.5 and Required Minimum Distributions after age 72 (not including Roth monies).

Business owners can consider Non-Qualified Deferred Compensation arrangements, of which there are several options beyond the scope of this article. Some might entertain Defined Benefit Pension plans, usually in unique instances with very high cash flow and a smaller employee base. Lastly, a business owner can take advantage of all the other traditional wealth accumulation vehicles; non-qualified investment accounts, real estate, cash value life insurance, and the equity within their business.

Consistent funding of a sound retirement plan coordinated with tax advisors and financial advisors can present the business owner with comfort as they approach retirement, whether working remains in the picture or not.

Bryan M. Kuderna, CFP, RICP, LUTCF is the host of The Kuderna Podcast, author of Millennial Millionaire and founder of Kuderna Financial Team, a New Jersey-based financial services firm.