As a Business Owner, When Should I Start Contributing to Retirement?

I know how easy it can be to get caught up in the hustle and bustle of running a company. You can get so busy that you even forget about saving for your retirement. We all know that’s never a good idea. Recently someone contacted me on Twitter asking this, “Justin, I’m a new business owner, and I have some extra funds? Should I start contributing to my retirement now?” That’s great that this new business owner is already starting to think about retirement! However, there is a process. 

There are three main points you need to consider as a business owner BEFORE you ever start contributing to a retirement account.

1. Do You Have a Business Emergency Fund?

That means you have roughly one month’s worth of company expenses set back. If you run at $50k a month, you’d have $50k a month set aside in your checking balance. Hopefully your accounts receivable are operating at greater than that. So basically you would have your balance running at somewhere between $50k to $80k, possibly even $100k. So you need to have roughly one month of expenses in excess of your accounts receivable in cash before you ever start retirement planning. That just gets you through the turbulence of life. Now I’m not so much a stickler for having another two or three months of cash, but you need a line of credit. A savings of some sort would work as well in the event you go through the hard times or a trough in your business.

You may be thinking Justin those are huge numbers! Well, ok then let’s bring it down. Let’s say your company operates at $5k a month. Then you need to have $5k in cash, and you have another $5k-$10k extra and some ability to get to it if you need to. That is why a line of credit is often advisable for a business owner. If you’re not comfortable with the debt, then set it back into a long-term savings account. That way you can make a couple of percent interest on it. Before you start saving for retirement individually, you have to make sure your business is healthy!

2. Is Your Business Process Secure?

Here’s what I mean by that. There are four types of business capital that you need to give attention to, in order to make your business process successful.

• Human capital—Are you planning on hiring anybody new in your business in the next 12 months?
• Structural capital—Do you have the systems in place right now to allow your business to operate efficiently? If you do not, then use the money you would save for retirement to build that out first.
• Customer capital—Do you have customer saturation or do you have one client that generates 50 to 60% of your revenue? If that is you, then don’t set money back for retirement. Spend the money on marketing. That could help diversify your customer base.
• Social capital—This is how you are perceived in the community. Is where you may want to get involved and charities or boards or endowments or things of that nature.

Before you go and systematically start pumping away money for retirement you need to have your business structured for success.

3. Are You Ready for Dividends Above Your Lifestyle?

I’m going to assume you have already set yourself up on a regular payroll. It doesn’t look like a yo-yo. You are getting a paycheck, and you’ve already done the budgeting for your family. If you don’t have that done, then you’re not ready for dividends. So before you start a retirement account, you need to have your personal life smoothed out so that you know exactly how much money you’re spending. Budget your life out. Only then would I look at starting a retirement account for you, the owner. Then I’d say let’s start pulling some profit of that business and get you going.

Well, Justin, that seems crazy! Not really. You can do everything I’ve talked about in less than a year if you are diligent. Once you’re there, if you have an extra $500-$1000, or however much money you have extra, that you can take from the company, then you can put it toward your retirement plan.

What Now?

Once you get started, the question then becomes, where do you go with your retirement? That question has to be broken up into two different tax brackets. There is a high-income tax bracket; I’m going to say that’s 20% or greater. Then there is a low-income tax bracket; which is 20% or less.

Contributing When in a High-Income Tax Bracket

Let’s deal with the high-income tax bracket first. For many business owners, that is where they find themselves in a very short timeframe. So the very first place I’m going to recommend before even get into the retirement accounts in this tax bracket is a Health Savings Account or an HSA. The reason for that is as a married couple you can put $6750 into an HSA to be used for medical expenses. If you don’t use it in that year than the money grows and you can invest it and use it later on for medical needs or retirement.

The reason why I am such a fan of an HSA is it is the ONLY account that I know of that you can get a tax deduction on the deposit going in and tax-free money coming out. So it makes sense to utilize that particular account first. Let’s MAX it out before all others.

Next, let’s look at your time in the business. If you have employees and you are a start-up, which is where this question came from, then you may want to look at an S.E.P. IRA.

Here’s what I say, check that first if you’re a startup business if you have employees. The rules say that you have to contribute to your employees’ accounts if three things are met.

1. Is if your employee is over the age of 21?
2. The employee made more than $600 in a calendar year.
3. This one is the key!!! The employee has been with you for three of the last five years; then you have to contribute. So here’s where this comes into planning. If you just started the business let’s say in January of this year and we are answering this question in August of this year, well, then those employees have not been with your business for three of the last five years. So you can contribute as a business owner to your IRA without giving to your employees this year, next year, and the following year. You have three years before you absolutely must contribute to your employees’ accounts. An S.E.P. IRA is a very inexpensive way to go without having to incur the cost of what the traditional 401(k) would.

Now let’s look at the situation where you have employees that have been with you for three of the last five years. That’s the time to start looking at a simple IRA or a 401(k). I’m personally a fan of the 401(k) because the prices have come down in establishing these plans and there are so many planning options that I can use when it comes to tax planning with a business owner. So if you’re in a high-income tax bracket, the order I would recommend is HSA, SEP and then 401(k). And you have to remember those little caveats to each one, but work with your investment advisor and CPA to choose what works best for you.

Contributing When in a Low-Income Tax Bracket

On the flip side of that, you have the low tax bracket. We would do that one a little different. For those in this tax bracket, I would look at maxing out the individual Roth IRA first. A Roth IRA grows tax-free. Additionally, high-income people can’t use a Roth. So if you’re not making in excess of the limits, you can utilize a Roth. You can put $5500 for each, a husband and wife, in that. So MAX it out!

Then switch to the HSA like we just talked about.

Finally, I would look at establishing a Roth 401(k). That’s a 401k with Roth provisions in it. A Roth 401(k) will allow you to establish an account that will let you put up to $18k for an employee into the Roth portion of the account. A SEP doesn’t do this, and a SIMPLE doesn’t do this. 

If you’re making some good income but the way your taxes work out you are in the low tax bracket, then a Roth 401(k) could be the answer. Now all a sudden, if you build the business right, the husband, and wife, can put aside $36k in for the Roth 401(k) and almost another $11k in an individual Roth IRA. That’s a lot of money you can put back that grows TAX-FREE! THAT’S AMAZING!

RELATED ARTICLE: a Comprehensive Comparison of Business Retirement Plans

Conclusion

So to go back to the root question. When should a business owner contribute to a retirement account? The answer to that is simple. Once your business is steady. Then depending on if you’re high-income earner or low-income or not you have two paths you can go down.  Now there are all sorts of variations, but I’m not going get into that and this video. We don’t want to wind up 15-20 years from now and find that all our net worth is tied up in our business. You want to start balancing out our assets by diversifying the profits.  I hope that makes sense to you. I’m taking a very complicated question and trying to simplify it like I often do. Obviously, there are a thousand different ways to go with this, but I wanted you to get the main idea.

As always, if you have questions about your specific situation, shoot me a message. Let’s continue making our lives at least “Financially Simple.”