The Retirement Income Source 42% of Small-Business Owners Are Relying On -- and Why It's a Mistake

We’re told we’re supposed to have an income source in retirement outside of Social Security, since those benefits alone aren’t enough to live on. For most of us, that means establishing a nest egg in the form of an IRA, 401(k), or both. But a large number of small-business owners have a different sort of backup plan for covering the bills in retirement: their businesses.

An estimated 42% of small-business owners say that their businesses will serve as their personal pensions, so to speak, according to data from New York Life. But that’s a dangerous proposition in several regards.

First, you never know how well you’ll manage to sustain your business when you’re older. Maybe you’ll have the energy to keep things running smoothly. Or maybe your health will start to decline, as tends to happen to seniors, and you’ll find yourself struggling to devote the time needed to keep that business afloat.

Furthermore, you never know when economic conditions might change or when a competitor might come in and steal your customers away. If either event happens, your business income might take a serious hit, and you’ll be left with few options to compensate. That’s why it’s crucial to save for retirement as a small-business owner, even if you expect to continue working in a similar capacity during your senior years. And the sooner you do, the more protection you’ll buy yourself.

Savings options for small-business owners

One good thing about owning a small business is having several retirement plan options to choose from. First, there’s the traditional IRA, which allows you to contribute up to $5,500 a year if you’re under 50 or $6,500 if you’re 50 or older. Contributions are made on a tax-free basis, so you get an immediate break for contributing. Withdrawals, however, are taxed in retirement.

There’s also the Roth IRA, which comes with the same annual contribution limits as its traditional counterpart. The main difference is that contributions are made with after-tax dollars and withdrawals are taken tax-free down the line. If you have reason to believe you’ll be in a higher tax bracket in retirement than you are at present, it often pays to opt for a Roth. That said, higher earners aren’t eligible to fund Roth IRAs directly, though there’s always the option to open a traditional IRA and convert it to a Roth later on.

If you’re looking to contribute more than $5,500 a year (or $6,500 if you’re 50 or older) toward retirement, you’re in luck, because as a small-business owner, you have access to two additional IRA types. The first is the SEP IRA, which allows you to contribute up to 25% of your net business earnings for an annual maximum of $55,000. The primary downside to opening a SEP is that you’re required to contribute the same amount percentagewise to your employees’ accounts as you do to your own. This means that if you allocate 5% of your salary to your SEP, you must contribute 5% of your workers’ salaries to their accounts.

There’s also the SIMPLE IRA, which allows you to contribute up to $12,500 annually if you’re under 50 or $15,500 if you’re 50 or older. If you open a SIMPLE IRA, you’re required to match employee contributions to a certain degree, either by providing a direct match of up to 3% of their compensation or by contributing a fixed 2% of your workers’ earnings.

Finally, there’s the Solo 401(k), which works just like a regular 401(k) only with a much higher annual contribution limit. Currently, you can contribute up to 25% of your net business earnings for a maximum of $55,000 if you’re under 50 or $61,000 if you’re 50 or older. Solo 401(k)s can be costlier to maintain than IRAs since you’ll need to cover their often-hefty administrative fees. But they’re also a good way to help grow your nest egg.

No matter which savings option you ultimately choose, don’t make the mistake of falling back on your business income alone in retirement. You never know how things will shake out with that venture once you’re older, and the last thing you want is to land in a situation where you don’t have enough money to pay the bills. Save independently, and with any luck, your nest egg, coupled with whatever income your business does generate, will be enough to not only sustain you during your golden years, but buy you the comfortable retirement you deserve.

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