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Retirement vs. Reinvestment: How Should Business Owners Plan for the Future?

By: Lending Tree

 

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When you’re a business owner, you — and only you — are responsible for your financial future.

As you grow your business, it can be difficult to tell whether you should save any extra funds for your retirement or reinvest them into your business.

Although strong cases can be made for both sides, consider making your retirement fund a priority. Starting a business is fraught with risks, but having a retirement plan ensures that your future is taken care of, regardless of what happens today. Here’s how to get started.

Determine your retirement timeline

As a business owner, you typically have more leeway in your retirement timeline than your salaried friends and colleagues. Some successful entrepreneurs are able to sell their business for a huge profit and retire early, while others love the work they do so much they plan on working indefinitely.

However, a survey of small business owners by SCORE found that 21% of its respondents didn’t own a retirement plan because they used the money to fund their business endeavors. While it may sound like a great way to get enough capital to start your business without taking out a new loan, this move puts your financial future at risk, especially if your efforts aren’t successful.

First, you may get hit with a 10% penalty for withdrawing any savings before you reach 59½ years of age. Withdrawing money from your retirement fund also means that you lose out on any exponential financial growth that account would provide.

When you deposit money into, say, your 401(k) plan, your money collects interest over time the same way it would if you put it in a savings account. The only difference: The interest you accumulate in a retirement fund accumulates interest over time as well — a phenomenon called compound interest. This means that the earlier you start saving for retirement, the more money you’ll stash away overall.

Of course, you can still decide to cash out your retirement account. It all comes down to how much risk you’re willing to tolerate.

If you’re young and just starting out, you have a longer timeline to work with and more opportunities to set aside money for your future. But if you’re older and would like to retire in the next few years, you may not want to risk gambling your retirement fund on a business endeavor that isn’t guaranteed to succeed.

Additionally, if you plan on retiring soon, you may be asking yourself if you should max out your 401(k) contributions in order to catch up to your retirement goals. However, doing so will “lock up” funds that you could otherwise use to grow a thriving business.

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Consider what other assets you have

When you’re just starting out, you may feel tempted to put all of your extra income back into your business. What many new business owners don’t realize, though, is that this leaves you without a safety net to fall back on when you run into financial trouble.

Before you go and reinvest all of your money back into your business, make sure that you have a diverse array of assets to protect your finances. Consider opening a retirement account — and the sooner the better, as you’ll find out in the next section.

Simplified employee pension (SEP) plans, savings incentive match plans for employees (SIMPLE) or self-employed 401(k) accounts all offer unique benefits that can help business owners and entrepreneurs save for retirement more easily.

Having a retirement plan in place can give you the financial security you need to make important decisions for your business with confidence. However, you’ll have to be diligent about funding your account regularly if you want to take full advantage of factors like compound interest (more on this below).

Check your business’s vitals

Many entrepreneurs start businesses with the hope that one day they can sell them for a handsome profit. If you’re one of them, you’ll want to keep an especially close eye on your company’s finances.

The financial health of your business has a huge impact on your retirement prospects, especially if you plan on only using your business to fund your retirement. Any prospective buyer worth their weight will take your company finances into account when considering the purchase.

But although selling a company for millions of dollars is the dream for many business owners, the statistics paint a sobering picture. Two out of every three small businesses fail within 10 years, according to the Bureau of Labor Statistics. And even if your business beats the odds, it may not be sustainable  — or you might not find a buyer willing to pay what you’re looking for.

Some businesses, particularly service-driven ones, aren’t attractive resale options. Ones with a high resale value are often those with revenue streams that aren’t tied to the business owner’s presence in the company, those with valuable proprietary technology or those with a large number of resources at their disposal.

It’s risky to rely entirely on the sale of your business for your retirement fund. After all, your industry may become obsolete. Future market conditions may prevent you from selling your business for its full value. Even if you put your heart and soul into your business, factors that are completely out of your control can lead to its demise.

A healthy retirement fund is your insurance policy against that. In the event that you’re unable to sell your business or make the profit you’re hoping for, your retirement savings will still allow you to retire comfortably.

If you’re set on selling your company to fund your retirement, the following tips can help shed some light on the health and long-term viability of your business:

  • Start assessing your company’s finances at least a few years before you actually plan on selling it. You’ll want to get your business affairs and financial documents in order for prospective buyers.
  • Expect potential buyers to ask pointed financial questions, including the kind of debt your business has incurred, how much revenue it brings in and its current market value. It’s difficult to predict exactly what questions they’ll ask, but an exhaustive knowledge of your company will prevent you from getting blindsided.

Weigh the tax consequences

Putting your money into a retirement plan offers you certain tax benefits, while pouring money back into your business offers you other ones. Consider the advantages each option gives you before you invest your money one way or the other.

Strategically reinvesting funds into certain aspects of your company can increase your revenue, so you can then allocate a portion of those funds for your retirement savings. When you purchase assets or improvements for your business, you can also save some money by capitalizing on these costs.

In addition to protecting your future from the volatility that typically comes with self-employment, a retirement plan can help you save money on income taxes as well.

As a business owner, you’ll have access to a variety of tax-deferred retirement accounts (like the SEP and SIMPLE IRA plans mentioned earlier) that don’t tax your income until you retire and withdraw the money. This allows your funds to accumulate interest at an exponential rate, especially if you started making contributions to your account early on.

Additionally, retirement plans like individual and small business 401(k)s allow you to deduct employer contributions and plan expenses from your taxable income too.

If given the option, most business owners would choose to put their money into both their retirement account and their company. However, the reality is that the majority of the self-employed have limited funds to work with.

Understanding your situation and your financial priorities can help you make the best decision for your business — and for your future.

Published: March 2, 2021
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Lending Tree

LendingTree is an online loan marketplace for various financial borrowing needs including auto loans, small business loans, personal loans, credit cards, and more. We also offer comparison shopping services for autos and educational programs. Together, these services serve as an ally for consumers who are looking to comparison shop among multiple businesses and professionals who will compete for their business.

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