Let’s be honest: Drawing down on your savings is just not a sustainable, or desirable, way to grow your business. Eventually, your business must generate enough money and/or receive some outside funding to sustain itself. While the business goes through this transition, you can smartly plan for your own financial future.
Saving for retirement, even a small amount, should be one of your top financial priorities as an entrepreneur. It will force you to put yourself first, potentially provide tax breaks on income and help you lessen the emotional and financial blow if your business falters down the line.
Now retirement savings probably isn't high on your list of priorities. As an entrepreneur, I can relate to the constant worry around trying to secure more revenue or funding. (Don’t fret—the psychological price of entrepreneurship is borne by many.) You constantly debate whether it's smart to use any extra cash to pay down personal debt, pump some money back into the business or just treat yourself to a spending splurge. And while things might look under control on the outside, you might be secretly worrying about how you will manage it all. With all that in mind, putting any money toward your retirement seems out of reach, right?
You have the power to choose what to do for your financial future. “One of the most important decisions a business owner can make is what they will do about their retirement options,” says tax and financial advisor Frank Abigana of Frank Raymond Inc.
What's Right for You?
The IRS has created a few special retirement vehicles specifically for entrepreneurs that provide extra incentives to put money aside for your (and your employees’) retirement. It's important to familiarize yourself with two retirement vehicles—a Simplified Employee Pension Individual Retirement Account (SEP IRA) and Solo 401(k)—that are designed specifically for entrepreneurs.
The SEP IRA is an individual retirement account that follows the same investment, distribution and rollover rules as traditional IRAs, which allows you to sock away money before you pay taxes, thereby lowering your tax base. A SEP has major benefits: It's easy to set up at most mutual fund companies, it has very low administrative costs, it's flexible on annual contributions (and thus a good plan if cash flow is an issue) and you can contribute to a SEP anytime before the tax filing date on April 15, or October 15 if you decide to extend the deadline. The major downside is that you must contribute equally for all eligible employees, so if you have a lot of employees, a SEP IRA is not a cost-effective option. The other downside is that you cannot take loans from a SEP, as with a 401(k), or take any money you’ve contributed without penalty as you can with a Roth IRA.
If you are a sole proprietor, a SEP IRA may be a good option to consider. As the only employee, you don't have to contribute to any other retirement account. With a SEP, you can contribute the lower of 25 percent of your net income or $52,000 for 2014 ($53,000 for 2015). If your net income is less than $20,000, it's smarter to open up a traditional IRA because you won't be subject to the 25 percent net income clause nor the rule that mandates you to contribute to an employee plan should you decide to hire more people.
In addition, sole proprietors have the option of setting up a Solo 401(k), also known as an individual 401(k). These plans are strictly for sole proprietors with no employees. A Solo 401(k) can be set up as either traditional or Roth, just like regular IRAs. A Solo 401(k) plan has a tax-deferred contribution limit of $17,500 in 2014, and a total contribution limit of $52,000 if the plan is set up for profit-sharing. Furthermore, you can borrow against your Solo 401(k) if you need to.
Even though you may already be familiar with a Roth IRA, it's worth underscoring its benefits. A Roth IRA is not specifically designed for business owners, but can be the friend of all—entrepreneur or not. With a 2014 annual contribution limit of $5,500, a Roth IRA is a powerful savings vehicle because you don't have to pay taxes on any gains you make from the investments. A Roth IRA is desirable because you can take out your original contribution to a Roth without penalty if you need the money for emergencies. If you have a low tax rate today—and many entrepreneurs do as they wait for their income to come in—a Roth IRA can benefit you. Remember, these retirement vehicles are designed to induce saving for the long term.
While you may think you will retire by selling your company for millions of dollars, the unfortunate reality is that most people will not. Riding off into the sunset because you've sold your company is great, but you can still prepare yourself financially. Even if you don't care about retirement, you will outsmart others by taking advantage of the tax breaks that are generous for the self-employed and small-business owners.
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