The Basics Of Pre-Retirement Planning
For Small Business Owners
There comes a time when an owner of a small business must ask two crucial questions: (1) How can I maximize the value of my business when I retire? And, (2) will the value of my business be adequate to fund my retirement years?
Business owners who fail to ask these questions until later in life may find themselves in shallow financial waters. But those who plan their exit strategies earlyworking with an experienced financial advisorshould be well positioned to transfer their businesses to new owners.
When working with small business owners, the financial planner should focus first on family or personal goals. This means gaining an understanding of the business owners long-term vision separate from the business. They then can devise a plan to help the owner maximize the profitability of the business and, thereby, secure the owners retirement.
The business owner and financial planner must surmount the financial obstacles that exist for small business entrepreneurs. Example: taxes exceeding 15% of gross income in Social Security contributions. They also pay health care benefits with no subsidies and all life benefits.
If they get sick or hurt and cant work, they have to figure out how to fund current expenses. If they die prematurely, they have to honor leases and debts of the business and provide income for surviving family members.
A common mistake small business owners make is having all their net worth in the business. In some cases, they spend years putting money into improvements on property they dont own.
For example, one of my clients, a small business owner, leases a 5,000-square-foot office space. He recently spent thousands of dollars installing granite countertops. When he leaves the business, this expenditure will have no positive impact on his retirement income.
Closely held business owners also must be aware of unique risks attached to their retirement savings. When a business owner signs leases or guarantees debt as a normal part of business operations, creditors can attach the individuals savings.
Business owners must therefore be vigilant in risk assessment by asking such questions as: If I get sick or hurt or die, who can take my money away from me or, more importantly, my family? What choices do I have? What tools do I have to preserve some of my wealth?
A financial planner can help the business owner answer these and other questions. Together, the owner and planner can focus on retirement goals and plan carefully to defer current income to fund the owners retirement years.
A planner also can help business owners determine an exit strategy, defining the desired retirement lifestyle, and timing the retirement date to coordinate with lease expirations and debt repayment schedules.
Once this information is gathered, the planner can help the owner determine how much money, factoring in inflation during the retirement years, he or she will need to support that lifestyle. The planner can then calculate how much equity or value must be saved outside the business to achieve financial independence. I call this the Walk-Away Fund.
Another of my clients is a 41-year-old commercial building contractor who has been in business more than 20 years and wants to retire in 10 years. His average income is $500,000 a year in pre-tax income and his current savings are less than $200,000.
To create a financial plan, we first looked at where his money was going. We did a cash flow analysis to determine how much leftover income he would have at the end of the year, after tax. Then we determined how much in annual income he would need to meet his retirement lifestyle goals: $110,000.
Our next task was to figure out how much money he needed to save to create that income, given his and his wifes risk for tolerance and volatility. As part of this process, we created a budget that he and his family must diligently follow for 10 years.
Two other clients are partners in an executive recruiting business. They are in their early 50s, have incomes of about $300,000 a year and have $300,000 to $500,000 in savings. Aware that their business will have little value to a buyer, they intend to lock their doors and walk away from the business 10 years from now.
Their challenge: how to accumulate more money without incurring a greater tax liability between now and then.
Before they contacted me, these individuals would not have been able to achieve their retirement objectives based on their savings. I made them understand they would need to set aside a lot more money each year if they intended to walk away and retire from their business as planned.
One thing we learned is they had not taken advantage of a defined benefit or defined contribution plan, such as a 401(k), or a profit sharing plan. So, we made sure they established a defined plan for their company.
Through the plan, they now deposit $200,000 in pre-tax dollars to create the income stream they will need for retirement. Granted, they have had to give up immediate gratification in the short term.
But they now appreciate the importance of doing this to gain a long-term benefit.
The clients realized that a future sale of their business is unlikely to be lucrative. They recognized that the real value of most businesses is in the relationships or good will the business owners develop with clients. And they understood that when an owner leaves the business, those relationships are not always transferable.
The only exception to this rule is when the sale involves a current employee or a family member. Selling the business to such a key insider is a complex process and takes at least 10 years of planning to complete successfully. The relationships developed over the years, which represent the true value of the business, are usually already in place with the key person.
For the sale to make sense, the successor must be at least a generation younger than the owner. Typically, during the 10-plus years of planning, the owner becomes a mentor to the junior person, which helps to increase the junior persons knowledge and strengthens and nurtures the junior persons relationships with clients.
In many cases, the sale involves the transfer of the business to a son or daughter who wants to follow in the parents footsteps. However, the sale can present financial issues if the business owner has more than one child and the other child or children have no interest in participating in the business. The challenge is to make sure those children who dont come into the business are not disinherited.
An example of this occurred with one of my clients who is a building contractor with three children. His son indicated he may want to come into the business; however, his two daughters told him they have no interest in it. When the son transitions into the business, it will have a value of about $1 million.
Without planning, if my client and his wife die, the son would get the business and the daughters would get nothing. To avoid this, we recommended the father consider life insurance as an estate equalization tool to provide for his daughters.
As the examples show, a financial planner must have broad expertise and complex knowledge to meet the needs of clients effectively in the small business market sector. A planner must be able to dovetail retirement planning with estate planning and business succession planning, all of which must be linked carefully, based on the significant impact they each have on the other.
In addition, financial planners must be current on tax laws and on the various business structures, such as limited liability corporations, family limited partnerships, plus C and S corporations. They also need to understand business finance, mortgage banking, and commercial and general real estate.
Most importantly, a financial planner must develop a solid network of bankers, lawyers, accountants and CPAs, real estate brokers, and other financial services professionals who can implement the tactics the planner recommends. The value of building strong relationships with these professionals is measurable and can determine a planners ultimate success.
The small business field is a good market, and it is growing. Today, there are relatively few financial planners qualified to compete in the small business field. Planners who have just completed their licensing and are just starting out would do well to seek out experienced, successful planners who work in this market and develop mentoring relationships to benefit from their years of experience and expertise.
Just as with small business owners, both foresight and thoughtful planning are a must to ensure a successful outcome.
Bryan Kettel, CFP, CLU, ChFC, LUTCF, is principal of Strategic Planning Partners, LLC, an affiliate of Prudential Financial, Newark, N.J. He may be reached at email@example.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, February 11, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.