After a couple weeks discussing retirement planning for your employees, let’s get to talking about your own retirement plans.
It’s common for business owners to put this task on the back burner. Unlike those they employ, small to midsize employers don’t usually have someone walking up to them with a form to sign up for their retirement savings program. Because it requires self initiative, lacks a due date, and no one’s following up with you if you fail to complete it (quite unlike your taxes), many employers put their personal savings plan in the “tomorrow” pile and never seem to get to it.
That’s an idea that any growth-focused entrepreneur should recoil at, and the upcoming state mandate for your employees is an excellent opportunity to get yourself in the savings game as well.
It may seem like another non-critical task, but you have a great opportunity this year to get your own future squared away at the same time you’re setting up a plan to be in compliance with the new state mandates
Reducing your own tax burden in the present, building long-term financial security for your future, it’s not a bad deal at all. If you’re able to deal with a little bit of homework right now, you can kill two birds with one stone and rest a little easier for the remainder of your working career.
Just a word of warning! Assuming you can just hop on a plan being set up for your employees might not be the best idea, or even possible (depending on the type of plan you’ve chosen). It’s a fair guess to say that you have different financial goals and responsibilities than those you employ. It’s worth taking a little bit of time to learn about what type of retirement savings plan will suit you best.
If you need a refresher on the features of different retirement plans, check last week’s post, it will get you up to speed so you’ll be able to follow along without issue.
Different Definitions: Defined Benefits vs Defined Contribution
As I discussed last week, there are many different types of retirement plans but they can all be categorized as one of two types
- Defined Benefit
- Defined Contribution
I’m not here to tell you that one is always and inarguably better than the other, as that’s just not the case. Historically, defined benefit retirement programs (pensions) were offered to employees by companies as an enticing factor to come work for them. Since their heyday of the 1960s and 1970s, the vast majority of companies have switched to defined contribution plans (IRAs, 401(k)s).
The beautiful thing about the number of savings options available to modern consumers is that everyone is able to find the product that best meets their needs.
The main defined benefit program you can set up for yourself is an annuity. If you weren’t already aware, annuities are a type of defined benefit plan that many business owners turn to as a means to establish a secure future for themselves at the same time they substantially limit their tax burden.
How do they work? In simple terms: you fund an annuity either through a lump-sum payment or by regular intervals. At the point where the annuity has matured (reached the amount of time agreed upon), you are able to collect it outright (your investment + interest – fees = value), or have it dispersed over a specified period of time.
How long does it take to mature? That’s up to you. You could choose any period of time the provider is offering, but in the terms of this conversation, you should try to decide when you’re hoping to retire. Just after that time is best so you’re not receiving extra income and paying unnecessary taxes.
The beneficial thing about annuities is that they literally allow the owner of the annuity, the annuitant, to write a contract that specifies a certain amount of money that they will get at a specific time in the future. All that’s required of them is that they meet the terms laid out in the present or near future and in the distant future they will be guaranteed a certain amount.
It’s also a huge plus that there are no contribution limits as seen with defined contribution plans. This makes annuities an excellent device for those starting their retirement savings later than they would have liked. It also makes them a crucial tool for high earners who want to avoid paying more taxes than necessary.
The terms of that contract are specific to each applicant and depends on the combination of their goals, income, health, and age (among other factors). As with all investing, there is a range from conservative to risky in terms of annuities. More cautious annuities (CITE) that promise returns, or riskier investments that offer the chance of bigger dividends, as with all financial strategies, this is a choice that you’ll have to make for yourself.
Put crudely, it’s essentially a gamble you make that you will receive more distributions in retirement than you invested earlier in life (i.e., you’ll live longer than the company selling you the annuity expects you will). If this seems strange, you wouldn’t be the first to think such a thing, but it can make a profound difference in your life, both before and after retirement.
The downside of annuities is that they are very illiquid and once you’re in, you have to to stick with it. If you want to make a withdrawal before the age of 59 ½ you might find yourself paying almost 20% in penalties on your own money! This makes an annuity a poor investment if there’s a good chance you’ll need a big chunk of money in the near future. Anyone considering funding college, buying or building a house, etc, should probably into different financial vessels for their savings. They also tend to have higher management and setup fees than other financial products.
All this speaks more about the need to diversify your savings than about how annuities don’t work.
It makes sense to speak with your financial professionals before making any decisions or purchases. There are a number of factors and considerations that come into play and you should consider what it is exactly that you’re looking for before rushing to buy any product or service.
You may have thought that being a business owner prevents you from establishing a personal pension of sorts, but as you can see, it’s entirely possible to do so.
Defined Contribution Plans: IRAs & 401(k)s
Defined contribution plans are more familiar to the public in the form of IRAs and 401(k)s. These plans promise nothing in terms of guaranteed benefits, but instead offer to invest your money along in the ways outlined by the financial planner. Ideally, the investments grow over time and are at their height when the account holder officially becomes a retiree.
This strategy does hope for a little bit of luck that you won’t need your retirement money at the exact wrong moment. Speaking with my mother about what she had done (she planned for retirement as well as anyone I’ve ever seen, always open to advice from her), she noted that in the 2008 crash, her investments shrank by 50%, but by the time she was retiring in January 2020 they had grown almost 900%. This real-life anecdote says two things that are true about defined contribution plans:
1. If you need your money at the wrong moment, you’re in big trouble.
2. If you can manage to hold on for a couple of years, you can almost always improve your position.
For much greater detail on the different types of defined contributions plan, I again encourage you to check out the post from last week that covers this topic.
Individual Retirement Accounts (IRAs) come in several different forms, with specific regulations but more or less all do the same thing. These financial tools allow you to prepare for your retirement with your hands if not on, certainly close to the controls. Your IRA can be filled out with almost any investment you’d be interested in making (stocks, bonds, cryptos, mutual funds, indexes), and you’ll get a more passive (and cheaper) management style. Essentially, your financial manager is driving your ship, but only to the coordinates you’re giving them.
The tax incentives are similar as seen with annuities, you can reduce your tax burden by whatever you deposit, and only pay it when you withdraw later in life. With Roth IRAs, it’s the opposite. Pay the tax now and NOT later in life.
If you’re self-employed or a small business owner, you might also be interested in both SEP IRAs or SIMPLE IRAs, both provide small business owners with the ability to reduce their tax burden by the amount of their contributions. These two types of account also have substantially larger annual contribution limits so you’ll be able to save much more, faster.
401(k)s are a more managed version of an IRA. Essentially the same tax rules for each 401-IRA equivalent, these financial tools allow you to get a little more aggressive with your retirement planning. You’ll pay someone more to manage it, that person will definitely be more aggressive with their decisions, and the hope is that your money will have grown substantially as a result of all that.
Keep in mind, I’m speaking in generalities here. It’s absolutely possible to reach out to a financial manager and explain that you’re interested in setting up a 401(k) but not interested in cavalier financial choices, you prioritize stability. No problem, there are plenty of advisors that share your sentiment and would be happy to help you.