Should You Save for Retirement or Reinvest in Your Business?
This is a question that would never come up if you are a salaried employee. In that situation, you’ll save for retirement, no matter what. But self-employment is always more complicated.
The entrepreneur has to make choices in regard to allocating assets in a way that will provide the greatest financial benefit. Sometimes that’s saving for retirement, other times it’s reinvesting in the business.
This debate has no clear-cut answer. Much depends upon your personal circumstances, and even on the nature of the business itself.
Let’s take a look at both sides of the argument.
The Argument for Saving for Retirement
This is certainly the conventional wisdom, and in many cases it’s the right choice. Here are some of the reasons why:
Tax benefits. Shielding income from taxes is almost always a priority for small business owners. Fortunately, retirement plan contributions are particularly generous for the self-employed. For example, using a SEP IRA, you can contribute as much as $53,000 for 2015. If you have a combined marginal state and federal income tax rate of 40%, making the maximum allowable contribution would save you $21,200 in income taxes—while increasing your financial asset base.
Diversification against the decline or loss of the business. Businesses don’t always have a happy ending. Some businesses end very suddenly, perhaps because of a change in government regulation, a lawsuit, or even the arrival of a particularly aggressive competitor. Other businesses just wither away, while the owner tries desperately to resuscitate the venture.
Losing a business would be bad enough, but losing it and not having any assets to fall back on will be far worse. A well-funded retirement plan can act as a diversification against the loss of the business. It means that even if the business owner has to start over again completely, he or she can do so with the strength of having a large retirement plan in the background.
Diversification of major assets. The time-honored saying is totally valid: never put all of your eggs in one basket. You might want to consider something like a gold backed IRA. This is a mistake commonly made by business owners. If most or all of your money is tied up in your business, then you are completely dependent upon a single major asset for your financial strength.
By putting a significant amount of money into your retirement plan, you achieve a diversification between major assets. This means that while you are busy maintaining and growing your business, your retirement portfolio is growing over time through investment in financial securities that are not in any way dependent on the performance of your business.
It’s a necessary step in a business with no serious resale value. Some businesses can be sold for a substantial amount of money. But that’s certainly not true of all businesses. In fact, many service businesses, particularly those where the business owner is essentially the business, have very little resale value at all. Should the owner decide that he wants to cash out one day and try something completely different, the sale of the business will produce very little in capital.
Translation: the business itself will not provide capital for the owners retirement.
A retirement plan can act as a dedicated capital accumulation plan, that nicely complements the business that has little or no resale value. And when the owner retires, the plan will be there waiting.
The Argument for Reinvesting in the Business
As compelling as the arguments in favor of retirement savings may be, there are equally valid reasons to reinvest in the business instead.
Reinvestment creates a higher income—and retirement savings. When capital is intelligently reinvested in the business, it enables the business to grow. As the business grows, so does the income to the business owner. This not only increases the owners income and financial resources, but it also makes more money available to contribute to a retirement plan.
This is especially important in the early days of business. The owner may need to build the business up to a critical mass, before expanding into nonrelated functions like a retirement plan.
Reinvestment lowers tax liability. When a business owner reinvests in the business, it typically lowers the tax liability. For example, when income is invested in physical assets, such as equipment, the purchase of that equipment can be written off through depreciation expense.
If the business is profitable, the IRS will allow it to write off the full amount of equipment purchased in the current year through section 179 depreciation. Otherwise the equipment can be written off over several years, which will create future paper expenses for the business. In either case, taxable income will be reduced.
For some entrepreneurs, the sale of the business IS their retirement. There are plenty of businesses that can be started, grown, then eventually sold to someone else for a substantial amount of money. Some businesses—started on a shoestring with very little capital—are ultimately sold for millions of dollars. That type of business venture can become a retirement plan in and of itself.
Such businesses are usually the type that have a large amount of physical assets, valuable intellectual property, or a cash flow that is likely to continue even after the current owner leaves business.
Entrepreneurs Seldom Retire. Even if a business is fairly informal, and will never be sold for a large amount of money, many entrepreneurs continue to work throughout their lives anyway. The concept of retirement is almost alien to entrepreneurs, because they enjoy what they do. Since they don’t have a boss, a cubicle, or a company handbook setting the parameters of their lives, there’s really nothing to escape from. They enjoy their work, and live for the challenge that only the business provides.
Final Thought
Under ideal circumstances, an entrepreneur will both reinvest in the business and fund a retirement plan. But if you have to make a choice one way or the other, these are some solid points to consider in the process.
