Starting a new practice can take time, effort and funds. However, it does not need to delay or derail your retirement savings. For entrepreneurs and small business owners, retirement can represent a level of financial independence defined by the ability to sell or walk away from their business. Steps to achieving that goal can take many forms.
Building financial independence can come from careful use—and eventual elimination of—debt. Student loans or capital financing to start your practice are some of the first investments you make in your future financial independence. Your first decision as you begin to earn income will be whether to save or spend. “Saving” includes deciding whether to pay down debt, redeploy the cash into the business or seek potential better returns elsewhere, such as investments in marketable securities. Each option helps promote your eventual goal of financial independence.
Investing in yourself or your business through debt is a powerful tool for building your financial independence. Don’t make the mistake of over-simplifying this equation by looking only at interest rates. Incurring debt, regardless of the immediate purpose, should only be taken on if it enables you as the business owner to generate income more than the net cost of that debt. Evaluating the net cost of debt includes evaluating the interest rate, the risk or additional cost of default and the tax impact of maintaining the debt. Seeking the proper source of debt, such as subsidized student loans or preferential small business loans, can reduce the net cost through reduced interest rates and favorable default terms. Working with a tax advisor can reduce the net cost by helping you take advantage of possible tax incentives associated with the particular type of loan. Consider working closely with loan officers, tax advisors and financial advisors to help you understand the true cost of your debt.
As your income grows, you will be faced with new savings opportunities. There are many options for business owners to set funds aside outside of the business for future use. The first step is identifying the specific future use, such as protection against unexpected costs, short term savings for personal use like buying a home, mid-term goals like saving for a child’s education or long-term use like saving for your own retirement. Short-term goals require flexibility and accessibly, often referred to as liquidity, along with minimal principal risk. The trade-off for low risk is low growth. Longer-term goals are achieved with the help of obtaining growth for the risk you are willing to take in investing those funds. Over-allocating to your short-term goals can come at the cost of foregone growth. Over-allocating to your long-term goals can come at the cost of painful early withdrawal penalties (illiquidity) or poor returns caused by bad investment timing (risk).
After identifying the intended future use, you may be able to obtain additional “growth” by reducing the cost of taxes associated with the savings vehicle. There are many strategies available to business owners to defer income taxes by saving into retirement-focused strategies, such as 401(k)s, IRAs, pension plans etc. There may be ways to avoid taxes on future growth entirely through the use of Roth IRAs or Roth 401ks. The right strategy for you will depend on many factors, including the cash flow of the business, the number and compensation of employees and the structure of the business ownership. Other savings vehicles with individual tax benefits may be available for different goals, such as 529 college savings plans or Health Savings Accounts. Lastly, the investments outside of a dedicated savings vehicle may have their own tax benefits, such as utilizing municipal bond income, holding assets long enough to receive long-term capital gains treatment or the benefits of qualified dividends.
There are many ways to use your hard-earned income to reach the goal of financial independence. The right answer will be different for each business owner based on the balance of options like debt financing terms, opportunities to reinvest within your practice or savings strategies outside of your practice. Moreover, your goals, options and resources will change over time. The most successful business owners recognize the need for an individualized plan, are willing to adapt over time and make the most of their team of advisors, including family, friends, mentors, tax advisors, financial planners and investment professionals.