Diversification of retirement assets for small business owners
With so much time and energy that goes into running and growing their businesses, small business owners sometimes think that their business is the primary asset that will provide them financial security in retirement (i.e., small business owners sometimes think they will work to run and grow their business for many years, sell their business, and then use the cash proceeds to fund their retirement lifestyle). After many years of hard work, selling a business could result in being an effective retirement strategy, but small business owners should not just rely on this possibility when planning for their retirement because if the sale does not go as planned or yields a lower than anticipated price, then their entire retirement savings plan would be negatively impacted. I will explain three reasons why sole reliance on the future sale of a business as a retirement strategy is risky and how to mitigate this risk by using another retirement savings option.
Uncertainties of the market
Just like any other asset, there are risks (e.g., economic downturn, increased competition, industry changes) that can negatively impact business value when small business owners are ready to sell their businesses. With these risks present, this means that even with business success throughout the years, there is no guarantee that small business owners will be able to secure a favorable price for (or even sell) their businesses in the future.
Timing is also a factor when small business owners are looking to sell their businesses. Small business owners might have a specific timeline for when they want to retire, but it might not necessarily coincide with the best to sell. Take the following hypothetical example to illustrate this point. Mark is age 40 and owns a market research company. He discusses with his wife, Lisa, that he wants to sell his market research company and retire in 20 years for several reasons that include family and health. This is an admirable goal, but there is still uncertainty about the availability and willingness of buyers of market research companies 20 years from now. At that time in the future, there could be many available buyers who are willing to pay a high price for his business or there might not be many available buyers at all.
Since small business owners devote so much time and money to their businesses, it is understandable that they could be emotionally attached, which might lead to them overestimating their business valuation. As a result, there is the potential for a disconnect between a small business owner and potential buyer of their business since the buyer would use more objective measures and might not value the business the same way.
“...sole reliance on the future sale of a business as a retirement strategy is risky.”
Tax implications
Like the sale of any other asset, there will be tax implications (depends on factors such type of business structure and duration of ownership) when a small business owner sells their business in the future, which results in lessening the total retirement savings amount available. Additionally, tax laws and regulations will inevitably change over time so there is a possibility that tax rates will not be favorable in the future when a small business owner plans to sell their business. Capital gains tax would apply if a small business owner sold their business for more than its adjusted basis.
Potential negative impact on legacy
Each small business owner has their own specific goals and family dynamics, but selling their business could jeopardize passing down a legacy to future generations. The potential of getting a sizable cash windfall from a business sale could be lucrative, but there could be other effective alternatives (if applicable) that will financially secure both the small business owner’s retirement and future generations.
Another retirement savings option: A small business owner retirement plan
In one of my previous posts, I discussed how small business owners must be proactive in creating their own retirement savings (and not just rely on the potential sale of their business in the future) and by not properly addressing retirement planning can lead to adverse consequences for a small business owner in the long-term. There are retirement plan options available to a small business owner that provide tax advantages (i.e., tax-deferred savings) and flexibility, which include SEP-IRA, Solo 401(k), and SIMPLE IRA.
Having a small business owner retirement plan in place provides diversification of retirement assets meaning that there does not have to be reliance on a potential business sale in the future. A small business owner still might decide to sell their business, but if they also have a retirement account, then this gives them more flexibility. Take the following hypothetical example, which explains how this flexibility would help. Given the advice of his financial planner, John sets up a SEP-IRA and plans to contribute to it annually over the next 25 years. John also has thought about potentially selling his business sometime in the future but wants to make sure he sells it at a favorable price when that time comes. John knows that at retirement, he will have a sizable amount saved up in his SEP-IRA, which means he will not feel pressured to sell his business at an unfavorable price and has the availability to wait for a buyer to offer a favorable price.