My dad was a small business owner whose engineering and consulting firm provided a solid income for him and supported our family. When he realized none of his four children were going to take over the business, he sold it at age 70. Dad didn’t have a retirement savings plan per se — the sale of the business was his retirement plan (plus Social Security and some rental income).
Will small business owners face a retirement crisis?
Turns out, the way Dad approached retirement savings is pretty common for small business owners today. And that’s more than a little troubling.
Why don’t more small business owners save for retirement?
As with my father, “the business is their retirement plan,” says David Deeds, the Schulze Professor of Entrepreneurship at the University of St. Thomas in Minneapolis. “The plan is that when they retire, they are either going to transfer the business to a family member in exchange for a share of future wealth or a buyout or they are going to sell it off and turn that into cash.”
Danger of a common approach
This all-your-eggs-in-one-basket approach can be dangerous for a variety of reasons, though.
“There is a risk level to it,” says Deeds, who is also editor-in-chief of EIX, the Entrepreneur & Innovation Exchange, a social media learning platform designed to improve the success rate of new business ventures. “If the business fails, your wealth goes away.”
And hopefully, a health issue doesn't complicate matters. When the Employee Benefit Research Institute surveyed retirees earlier this year, 55 percent of those who retired earlier than they’d planned did so due to health problems or disability.
Why entrepreneurs aren’t saving much
For small business owners, it’s not that they don’t want to save for retirement outside of their businesses. Their priority is to plow earnings back into the business to keep it growing, so they rarely pay themselves a big salary.
“If you are a small business owner, much of your wealth is trapped in your business. The problem is in order to diversify that wealth, you have to remove that wealth from the business, and, in essence, remove some of the lifeblood from the business,” Deeds says. “Taking money out impinges on growth prospects and it can make it hard to maintain the business.”
Another reason for the shortage of retirement savings could be that many businesses are fairly modest.
Dave Bensema, regional leader of planning, Illinois at BMO Wealth Management, says entrepreneurs need to take time away from working in the business to spend more time working on the business. “A key question for business owners, whether from a retirement perspective, a potential sale or even the continued operation of a business is 'Does the business run without me?'" says Bensema. If the answer is no, there could be difficulties valuing the business, finding a buyer or even generating income from it when you’ve left or are less active in it, he notes. “Once you know what income might be, then you can back into how much you need to save,” adds Bensema.
Here are five ways small business owners can ramp up their savings for retirement:
1. Run your numbers. Ask yourself: How much will I need to live on in retirement, especially when the business isn’t picking up the tab for some expenses? Just getting a sense of what your living costs might be when you quit working could be the retirement-savings wake-up call you need.
2. Consider hiring a financial adviser to jump start your retirement plan and help you focus. I recommend one with the Certified Financial Planner (CFP) designation.
3. Start a diversified retirement plan. You don’t have to throw a lot of money into it, but the funds will help trim your tax bill now and grow tax-deferred until you make withdrawals in retirement. In most cases, the cost of opening and administering a plan is pretty small.
The four main options: a SEP-IRA, a SIMPLE IRA, a solo 401(k) and a SIMPLE 401(k). For all but SEP-IRAs, a business can be a sole proprietorship, a partnership, a limited liability company or a corporation.
A SEP-IRA is a tax-deductible retirement plan like a traditional IRA and great if you’re the company’s only employee. One caveat: If you have employees, you generally must also fund SEP-IRAs for them.
A SIMPLE IRA is a retirement plan for owners with 100 or fewer employees. Contributions are pre-tax and taken directly out of employee paychecks, similar to a 401(k).
A solo 401(k) is for self-employed people without employees (except perhaps a spouse). The IRS let you contribute, pre-tax, up to 25 percent of your compensation plus an employee’s contribution of up to $18,000 (or $24,000, if you’re 50 or older) in 2016. If your spouse works with you, she or he could also put in the same amounts.
A SIMPLE 401(k) is for businesses with 100 or fewer employees. You and your employees can borrow against the money in your 401(k) accounts and make penalty-free withdrawals due to financial hardship.
4. Keep it simple. When investing, go for a globally diverse mix of low-cost index funds (or ETFs). You might buy three funds: an index fund that invests in the entire U.S. stock market; one that owns developed foreign stock markets and a smattering of emerging stock markets and an index fund that owns the broad U.S. bond market.
Simpler still: invest in a target-date fund that automatically adjusts the balance of your fixed-income (bond) investments and stocks based on your age. Select your target-date fund based on the year you expect to retire.
5. Check out 401(k) plans targeted to small businesses. Some 401(k) providers are actively targeting small businesses these days.