Summary: Business owners can’t save enough for their retirement because of the cash flow demands. 401k, and profit sharing plans limit their contributions, consequently they don’t save enough for retirement and have to depend on the value of their company for their future security. Unfortunately, only a small percentage of companies sell. This creates the Gap in their retirement planning.
By Thomas J. Perrone, CLU, CIC
One of the biggest retirement planning problems facing successful business owners is not earning enough money to retire.
It is the inability to put enough money into a traditional 401(k) or other contributory retirement plan to replace the income they are accustomed to earning.
For many business owners, this problem becomes especially important during the final three to five years before retirement.
The Contribution Limitation Problem
A business owner may be earning $250,000, $300,000, $400,000, or more per year. Naturally, as retirement approaches, the owner wants to accumulate enough retirement capital to maintain a reasonable percentage of that income.
The problem is that a traditional contributory retirement plan does not necessarily allow the owner to contribute in proportion to his or her income.
The amount the owner can contribute may be affected by the plan’s design, employee participation, employee compensation, nondiscrimination requirements, and applicable contribution limits.
This creates an important question:
How do you fund the retirement needs of a highly compensated business owner when the traditional retirement plan limits how much that owner can put away?
Consider a Simple Example
Imagine a business owner earning $250,000 per year.
Now compare that owner with an employee earning $100,000 per year.
Both may participate in the same 401(k) or contributory retirement plan. Yet the business owner’s retirement income need is substantially greater.
If the owner wants to retire at a level that is reasonably close to his or her final earnings, the amount that can be accumulated through the traditional plan may not be sufficient.
The employee earning $100,000 may have a much more manageable retirement funding objective.
The owner earning $250,000 has a much larger gap to fill.
And this becomes even more significant when the owner is only a few years from retirement.
The Last Three to Five Years Can Be Critical
Many business owners spend decades building their companies.
They reinvest profits.
They purchase equipment.
They hire employees.
They expand facilities.
They build working capital.
They grow the value of the business.
As a result, much of their wealth may remain inside the business rather than inside a retirement account.
Then, three to five years before retirement, the owner begins asking:
“How am I going to turn the value I’ve created in my business into retirement income?”
That is when the limitations of a traditional contributory retirement plan can become particularly apparent.
Trying to solve a lifetime retirement accumulation problem during the final few years with a plan that has contribution limitations may simply not work.
The Real Issue May Not Be Your Retirement Plan
This is why I believe business owners need to look beyond the question:
“How much can I contribute to my 401(k)?”
The more important question may be:
“How am I going to convert the wealth I’ve created in my business into the retirement income I want?”
Those are two very different questions.
A 401(k) is an important retirement planning tool. But for a successful business owner, it may be only one piece of the overall strategy.
The business itself may represent the owner’s largest asset.
The challenge is developing a coordinated strategy for:
- Building business value
- Protecting business value
- Accumulating retirement assets
- Creating additional sources of retirement capital
- Reducing unnecessary taxes
- Preparing the business for transition
- Converting business equity into personal wealth
Don’t Wait Until Retirement Is Five Years Away
The earlier this issue is addressed, the more alternatives may be available.
If you are a business owner earning substantially more than your employees, don’t assume that maximizing your 401(k) contribution automatically means you have maximized your retirement planning.
Your business may be producing significant income today while simultaneously creating a retirement funding gap for tomorrow.
Most business owners don’t have a retirement savings problem. They have a business planning problem.
The goal should not simply be to put as much money as possible into a qualified retirement plan.
The goal should be to develop a coordinated strategy that allows you to grow, protect, and eventually transition the value of your business into the financial resources you will need after you stop working.
That requires looking at the entire picture—not just the retirement plan.
The Bottom Line
If you are a highly compensated business owner, especially one earning $250,000 or more, take a close look at the relationship between your current income, your retirement income goal, your retirement assets, and the value of your business.
If there is a significant gap, don’t wait until the final few years to discover it.
Your business may be your greatest retirement asset—but only if you have a plan for turning its value into personal wealth.
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