Should a young entrepreneur save for retirement?

[IPAfan]

I know the general wisdom on this board is to always save for retirement, contribute to 401k up to the match, fund ROTH IRAs, etc., etc. This advice seems geared toward people starting conventional careers with an employer.

In my own business I'm finding that I can earn much higher returns by plowing money back into the business rather than investing in any conventional source. Unfortunately, these business returns are taxed much more heavily than returns that I make in my retirement accounts. Still, I think the higher rate of return might outweigh the tax consequences.

For instance, lets say I have $10,000 to invest. I can slap it in the ROTH accounts or plow it back into the business. If I put it into the ROTH account, I can earn AT MOST 15% a year (which is probably unrealistically high for a long period of time.)

If I put that money into advertising my business I will probably make $40,000-$50,000 in revenues. Let's use $40k as a base scenario. Then I keep about 70% pretax (this usually includes the advertising expense, but I'm being conservative so we'll assume that I make 70% AFTER subtracting for advertising).

So let's say $30,000, then I'm looking at about $21,000 in pretax net business income in ONE YEAR from a $10,000 investment. My overall tax rate including SE and income tax is about 35%. So I'm looking at a ONE YEAR RETURN of about $13,650 NET OF TAXES. This is with conservative numbers from my own business.

The big flaw with this analysis is that I WORK for the net income. Still, I'm looking at the fastest way to increase my net worth and am willing to put in extra work (and plan to start more delegation of lower value tasks).

Anyway, there's no way I can earn returns like this by investing in any asset class other than my own business. Obviously the only reasons I can earn high rates of return is: 1) sweat equity; and 2) I'm dealing with fairly small investments. Once I've invested a lot more into my business I'm sure that my incremental returns on additional capital are going to decrease.

It makes sense for me to start putting money into retirement accounts when investing in my own business is earning less than 20% pretax.

So, keeping in mind all the above, is there any reason to consider investing in retirement accounts? I think that putting money in retirement accounts is simply going to give me less capital to grow my business (and it's taking everything extra I've got right now).

Any ideas from other entrepreneurs out there?

[IPAfan]

To give a bit more of the picture. If considering pre-tax retirement accounts. My marginal income tax rate is about 20%..

[IPAfan]

To give a bit more of the picture. If considering pre-tax retirement accounts. My marginal income tax rate is about 20%..

[Deleted]

I'm not an entrepreneur, but my understanding is that most small businesses fail within the first 5 years. On the one hand, a good way to ensure that your business isn't on the wrong side of that statistic is to continue to invest in it. But on the other hand, investing in your retirement in a more traditional sense protects the assets should anything happen and you need to move on to another venture.

I'd probably seek some sort of balance on this one - set aside some money for your retirement and reinvest the rest to grow your business. You'll have to decide if 5k and 5k is the right balance, or another way to divide the money. But there's something to be said for carrying an umbrella - surest way I know to keep it from raining.

[MN-Investor]

When people here talk about investing for retirement, they are really talking about having a nest egg available to live off of at the date you want to retire.

There are many ways to create that nest egg. For many of us, investing within a 401(k) or an IRA makes the most sense. Other people own rental properties or their own business.

Building your own business is a wonderful way of investing for the future. I used to work for a large corporation. I remember one time when the company had some spare cash. Someone asked my boss why we didn't just buy stock of other companies with that cash. He said that made no sense. If you want to invest in GE, for example, then you're essentially saying that you have more faith in GE than your own company. If you truly think you'll get a better return from GE than from your own company, then you would be doing your stockholders a favor by just divesting yourself of your business and putting all your money into GE. But if you have more faith in your own company, then put the money to work in it.

So put your money where you think you'll get the greatest after tax return. Your goal is to build your net worth. Specific retirement vehicles are only one option available.

[IPAfan]

Very good point craftysarah. The catch 22 is that most businesses fail because they don't have enough capital. Fortunately my business requires practically no fixed assets (other than that I need a reliable car and reliable laptop and smartphone).

I had really OVER contributed to retirement accounts all through school. I'm trying to catch up on the rest of my financial plan and letting the retirement accounts do their own thing. I've been working so hard to contribute to retirement accounts even when we had almost no income that it's tough to see them stagnate while I work on other goals (like building a legitimate business, paying off debt, and someday buying a house).

To make the (short term) picture even worse, now DW wants to go to law school so she can work with me down the road. So I'm going to try to put her through school which will probably take up any extra capital we could throw at retirement or the business.

On the bright side we do already have a decent base of ROTH IRA funds that should help out a lot in retirement (probably 40+ years since I'm 27 and people seem to work a long time in my field).

[IPAfan]

MN-Investor,

Very good points. That's basically the perspective I'm taking right now. It's not that I have the best business in the world, but because I'm in a fairly good profession and have a new business, I'm earning large returns on the money I put into the business right now.

While I was in college/law school most of our improvement in net worth came from good investments. We were blessed to have earned very abnormally high (and unsustainable) returns over the last 10 years (nearly 20% annually). However I'm finding that my business can increase our NW much faster than investments.

For instance our NW has increased by just over $20,000 since the beginning of 2011. We've got about $41,500 in ROTH accounts. At the beginning of the year we had a comparable amount in retirement accounts (maybe $40,000) but $11,000 in CC debt, and about $3,000 in cash. Now we're down to about $1,000 in CC debt and about $12,000 in cash. Again, all of that is business income, but I've got to watch out for taxes too.

However, in 2010 (first year of my business) I earned much less money. I think this was because I was learning how to run a business, and more importantly I was starving my business from capital.

I'd really love to find a way to fund my own business through self directed retirement accounts. I've done a lot of research, and it's very difficult to legally do this. I think it would be possible to lend money to my business if my family owned less than 50%, but that would mean becoming partners with non-family member attorneys, and I just don't think it's worth it right now.

[MN-Investor]

You might do well to deal with a financial adviser with an associated tax person who specializes in professional corporations. I know, I know, you have a law degree, you ought to be able to do this on your own. However, spend your time earning money with your specialty, and pay someone else for their knowledge and experience. They may have tricks up their sleeves that hadn't occurred to you because that is not your area of expertise. It's amazing how good someone can be when they've worked on the finances of 100 personal corporations. It will be money well spent.

[dancinmama]

May 29, 2011 18:54:11 GMT -5 MN-Investor said:

When people here talk about investing for retirement, they are really talking about having a nest egg available to live off of at the date you want to retire.

There are many ways to create that nest egg. For many of us, investing within a 401(k) or an IRA makes the most sense. Other people own rental properties or their own business.

Building your own business is a wonderful way of investing for the future. I used to work for a large corporation. I remember one time when the company had some spare cash. Someone asked my boss why we didn't just buy stock of other companies with that cash. He said that made no sense. If you want to invest in GE, for example, then you're essentially saying that you have more faith in GE than your own company. If you truly think you'll get a better return from GE than from your own company, then you would be doing your stockholders a favor by just divesting yourself of your business and putting all your money into GE. But if you have more faith in your own company, then put the money to work in it.

So put your money where you think you'll get the greatest after tax return. Your goal is to build your net worth. Specific retirement vehicles are only one option available.

I guess it would depend on the business. Our neighbor across the street is a commercial door salesman, but he doesn't really pound the pavement to sell doors. When there is a commercial project (a new grocery store or a new school being built), requests for bid come over his fax machine. He bids the project and if he gets it, he orders and delivers the doors when they are needed. He does not hire installers or do anything beyond delivering the doors. He does have a warehouse where he keeps doors between the time he orders them and the time that they are needed on the project. Apparently in the good times, the warehouse was constantly full of doors; now, not so much.

A couple of years ago he mentioned that he planned to retire about now, but his son told us that he can't retire cuz his business "isn't worth anything". So I guess it really depends on what kind of business you have and what the state of the economy is when you want to retire.

I do have to say that this guy and his wife live VERY WELL. They live in a very nice home, have (3) high end luxury cars between them, take their very fancy boat out about (4) times a year, have all sorts of hired help (pool guy, housekeeper, pet person, and gardener), wear designer clothes even when they are just taking their dogs for a walk, etc. BUT he can't afford to retire.

The only other thing that I do know is that as of about 3 years ago, he did not actually OWN any of the cars (leasing or making payments on 5 cars at that time).

[IPAfan]

I 100% agree with you about getting an experienced professional for the tax angle of incorporation instead of trying to figure this out myself.

Sure I'm capable of boning up on tax laws, etc., but it's easier to pay someone who's already obtained that specialized knowledge and work on peddling my own trade.

However I'm not sure if I'm quite ready to make the leap into incorporating. I'm pretty sure it will make sense in the long run, and I will probably be able to save money on taxes. However, I've just got a million priorities right now and this one is on the back burner.

At this point I think the next big investment in my business will be hiring an employee. I'd like to have $25,000 in cash reserves before I take the plunge, so I'll keep saving for now. I think once I hire an employee I can devote more time to low cost advertising (I've got some ideas about really beefing up my referrals sources, but they are going to take a lot of my time).

[phil5185]

I don't know the optimal plan for you - but the max contribution on a SEP IRA is $49,000. So if you wanted a retirement account as backup that is available. The longterm (20 to 30 yr) return is about 11%/yr altho the general market doubled in the last 24 months - so your current 15% is probably not to be counted on.

[formerexpat]

Why not plow the money into the business and then instead of taking it out as net income [after paying a bunch of taxes on it], you turn around and put as much as you can in a solo 401k [up to $49k per year].

Kind of the best of both worlds.

[brdsl]

I would contribute to the retirement accounts. Here is my reason... I am not sure what your business is, but without fixed assets...the ease of entry is probably lower in your field. It might be able to be copied easily, and cut into your profits.

Think of your retirement accounts as a fall back...worst case scenario. Also for diversification...not all eggs in the business basket.


I could be completely off, but your 27, and if you retire at 57, your business will need to be around for all of those years, if you keep reinvesting, without retirement investments.

[IPAfan]

Phil,

I actually have about a 20% annual return going back to 1999, but again I think that's very unsustainable and I've been crazy lucky (blessed). I made some very good investments in gold (in 1999) and then in MLPs and other stocks in 2008/2009 which account for most of those gains.

expat,

definitely going to consider the SEP IRA when I have enough money to make serious contributions. Right now I'm trying to at least build up a cash buffer so I can grow my operating expenses without taking too much risk. I'd love to have 6 months operating/living expenses in cash, but that could mean $50-$60k after I grow my business to scale. Right now I need about $2,500 a month in business overhead and $4,000 a month for living expenses. I expect to grow the overhead with a little more advertising, and another $3,000 or so on hiring a secretary/assistant.

brdsl,

Totally agree about low capital businesses usually having a low barrier to entry. However, I've got a bit of a barrier to entry. I'm a criminal defense lawyer. So, first you have to have a law degree (and pass the bar, which in CA is under 50% right now...which boggles my mind, but that's another story) to compete, and second you have to be willing to represent criminals
There's still plenty of competition, but I think I'll make it. I'm actually trying to become competent in a very niche area of criminal defense which is preparing Petitions for Writs of Habeas Corpus. There's basically unlimited court appointed work available to represent death penalty inmates on habeas petitions (there's a wait of YEARS to put people to death in CA just because there aren't enough lawyers to handle the petitions.) You've got to be very competent though before handling death penalty appellate work.
I'm doing a lot of run of the mill criminal defense (half DUI and half assorted non-sex felonies...I DO have a line in the sand ), and some low level appeals right now. In 30 years I expect to have found my way into a niche without much competition. Habeas work is too much of a PITA to garner much competition even if the money is right.

In terms of reinvesting until I hit 57...I doubt I'll have the chance. Right now I'm earning huge returns on the money I put into the practice, but I suspect my returns will diminish as I invest more money into the business. I'd definitely want to start diversifying if I can earn similar amounts in the stock market.

I know a lot of lawyers who practice pretty much until they're dead. Most of the criminal defense lawyers I know making big money are in their 60s or even their early 70s. Who knows how I'll feel about my profession in 30 years. Right now I love it (equal parts doing something I like and doing it FOR MYSELF).

[swamp]

May 30, 2011 6:28:48 GMT -5 Lady Gaga Gaga Snerd said:

As an entrepeneur, you have a greater need to save for retirement, to set aside money for illness and disability, to obtain a hefty disability policy on oneself and EF. And, having been self employed and in business as well, you are underestimating the true value of benefits that employees have that you don't. So, it would be very wise to have a good plan and regular contributions. And, maybe your business will never have a hard time, who knows? What if you become temporarily disabled or something? It happens. You need a reserve. Saving for a rainy day is good advice for everyone.

[tskeeter]

Beer, there are a couple of reasons that I can think of to save for retirement outside of your investment in your business.

First, in many states, retirement funds are protected from creditors in the event of a lawsuit or bankruptcy. Prudent risk management would indicate that you shouldn't leave 100% of your resources exposed to problems in your business.

Second, even though your business has great value while you are running it, the value may not remain when you leave the business. Here is an example of what I am thinking about. A 70 year old customer of my Dad's decided to retire, and sold his business to one of his employees. Of course, the sale was owner financed, as are most small business sales. After about a year, the new owner notified the former owner that he was going to default on the business purchase loan and was returning the business to the former owner. There were several issues with the former owner getting the business back. The biggest issue was that the new owner had alienated many of the customers, so the business that was returned to the former owner was about 25% the size of the business that had been purchased a year earlier. At over 70 years old, the former owner had to begin rebuilding the business he had invested a lifetime to build. The flow of retirement funds that the former owner had anticipated from the sale of the business stopped. At a time when he had planned to retire, the former owner was forced to return to operating the business in order to protect what was left of his lifelong investment. Don't think I'd want to find myself over 70 years old, with my retirement investment pretty well destroyed, and having to return to work to pay the bills and rebuild my business.

[The J]

The numbers look lopsided, but that's because you're starting out and growing your business. At some point, your marginal returns from advertising will diminish, particularly as you grow the business to the point where you need associates. As you've noted, growing the business requires two investments: time and capital. The growth of retirement funds requires capital. It's a whole different calculation.

[commentator]

Should a young entrepreneur save for retirement?

Yes.

[tskeeter]

Beer, as I take the time to read through these posts, I see that you are an attorney. You are providing a personal service. Without you providing the services, your business is essentially worthless. Add a couple of associates; does the value of your business increase? Not really. I don't know if legal offices use employment contracts or if they employ at will. I suspect the latter. So there would be nothing keeping your associates working in your office. They could leave at any time, and are especially likely to leave on a change of control of the business. And they would probably take a chunk of their clients with them, because, they too are providing personal services.

The bottom line is that personal service businesses have no inherent value. There are no long time customers loyal to the business, not an individual, there are very few fixed assets which have significant value, even the inventory would be worth only several hundred dollars. The services have value, but not the business.

Why would you tie up all of your resources in a business that has almost no inherent value?

[IPAfan]

Snerdley,

I don't think I'm undervaluing employment vs. being self employed. I honestly know that I'd be better off with a decent paying job, benefits, and security. Still, that's not what I want. I want to be self employed. I'm tired of working for other people, and don't know that I ever want to do it again. I've got a lot of financial goals that I need to meet, but fortunately I'm doing OK. I've got no SLs, only $1,000 in CC debt (at 0%), and about $52,000 in financial assets right now. (I also own some decent used cars outright). So I think I could do better employed, but I think we can make it.

EF: I completely agree. In fact I've been pretty much devoting all my cash to paying off debt and saving cash this year. I've been plowing back some of that into the business, but I still need a lot more cash. Just for the business/personal EF I'd like to eventually have $50-%60k in short term assets. If I wanted to put a 20% DP on a house that would be another $50k in cash. That's my big problem with saving for retirement at this point since I need so much more cash stashed away.

Tskeeter - I see what you're saying, but completely disagree about service businesses having no intrinsic value. I can see what you're saying since at this point my business relies totally on my services to make a profit (and I'd probably make just as much as an employee including the benefits). However, that's because my business is just starting out. I know several attorneys that have taken a much more passive role in their practices and earn good financial returns. Again, the reason for putting money into my business is that I can get CASH RETURNS from those investments in less than 1 year. So basically I'm not tying resources up for a long period if time.

TheJ - I agree, numbers are skewed because I'm just getting started. I'm aiming to increase my overhead from about $6,500/month (including what I need to live on) to about $11,000/month. At that point I suspect that I'll be getting lower returns on incremental capital, and would probably start diverting money elsewhere.

Finally: Remember that I've only got about $12k in cash. I think I need a LOT more cash just to comfortably put more into my business (or retirement). I could see working on the EF for a couple years. It seems like forever, but not sure what other options I have.

[rovo]

Seems like I remember about a year ago suggesting you to forget about investing and to grow your business. Right now your fastest path to prosperity is your business.

[IPAfan]

Father rovo is usually right

[brdsl]

May 30, 2011 18:20:57 GMT -5 rovo said:

Seems like I remember about a year ago suggesting you to forget about investing and to grow your business. Right now your fastest path to prosperity is your business.

As long as your single asset keeps performing well....

[midjd]

I'd say you're probably best off investing in your business ONLY IF this includes some good short-term/long-term disability insurance. You want to ensure you can support yourself if something happens prior to retirement.

[IPAfan]

Agreed that I really need to check into short term and long term disability as well as additional term life insurance (only have $250k right now which is way too low). My medium term investment is to put my wife through law school (sounds chauvinistic, but it WILL be a good investment, and SHE's the one who wants to become a lawyer). Of course, that's another reason to work on growing the business. DW says she wants to work with me after doing law school. Even if we both make what I'm pulling in now in my second year of practice, we'll be paying way more in taxes than I like to think.

My practice doesn't require a lot of capital to grow. I suspect once I reach my targeted overhead of about $11,000 a month (including $4,000 to me) the practice should throw off a lot of free cash that can be invested elsewhere. Right now my gross is averaging only about $9k a month so I've obviously got a long way to go. I do think I can grow the top line if I can delegate clerical work. Eventually I will start delegating higher dollar tasks like paralegal and attorney work as well.

[qofcc]

I think for now that investing the money back in your business is going to be the best use of your money AT THIS TIME. Once your business is established and/or you get closer to retirement age, you need to switch tactics and start accumulating assets outside of the business, whether that is stocks, real estate, etc. You may think you have a perfect business model with a service that will never become obsolete, but things beyond your control can change and businesses can fail and leave you with nothing. You could get sued, become physically or mentally disabled, get divorced, have unforeseen competition from a person or technology, your geographic area could take a hit, etc. It's too risky to have all of your eggs in one basket in the long term.

[AgeOfEnlightenmentSCP]

May 29, 2011 18:26:37 GMT -5 IPAfan said:

I know the general wisdom on this board is to always save for retirement, contribute to 401k up to the match, fund ROTH IRAs, etc., etc. This advice seems geared toward people starting conventional careers with an employer.

In my own business I'm finding that I can earn much higher returns by plowing money back into the business rather than investing in any conventional source. Unfortunately, these business returns are taxed much more heavily than returns that I make in my retirement accounts. Still, I think the higher rate of return might outweigh the tax consequences.

For instance, lets say I have $10,000 to invest. I can slap it in the ROTH accounts or plow it back into the business. If I put it into the ROTH account, I can earn AT MOST 15% a year (which is probably unrealistically high for a long period of time.)

If I put that money into advertising my business I will probably make $40,000-$50,000 in revenues. Let's use $40k as a base scenario. Then I keep about 70% pretax (this usually includes the advertising expense, but I'm being conservative so we'll assume that I make 70% AFTER subtracting for advertising).

So let's say $30,000, then I'm looking at about $21,000 in pretax net business income in ONE YEAR from a $10,000 investment. My overall tax rate including SE and income tax is about 35%. So I'm looking at a ONE YEAR RETURN of about $13,650 NET OF TAXES. This is with conservative numbers from my own business.

The big flaw with this analysis is that I WORK for the net income. Still, I'm looking at the fastest way to increase my net worth and am willing to put in extra work (and plan to start more delegation of lower value tasks).

Anyway, there's no way I can earn returns like this by investing in any asset class other than my own business. Obviously the only reasons I can earn high rates of return is: 1) sweat equity; and 2) I'm dealing with fairly small investments. Once I've invested a lot more into my business I'm sure that my incremental returns on additional capital are going to decrease.

It makes sense for me to start putting money into retirement accounts when investing in my own business is earning less than 20% pretax.

So, keeping in mind all the above, is there any reason to consider investing in retirement accounts? I think that putting money in retirement accounts is simply going to give me less capital to grow my business (and it's taking everything extra I've got right now).

Any ideas from other entrepreneurs out there?

Speaking as a debt-laden (business debt), risk-taking entrepreneur-- yes. We have always saved using fund indexed to the S&P 500. We also have a full EF-- very full.

The reason is as simple as the simplest investing advice you ever got: diversify. You should never have all your eggs in one basket-- even if you own the basket. Maybe especially if you own the basket.

[thyme4change]

If you build your business up would you be able to sell it - or is it just you and your brain that you are selling?

If your business is just your brain, you either need a plan to make your business inherently valuable without you, or you need to save.

[IPAfan]

It is possible to sell a law practice if it's set up right. Could I sell my practice now? No.

[thyme4change]

Honestly, you need to have a solid business plan on bringing in associates and partners. Not saying you need to do it now, but you need to write out some goals with lever points on income on where it makes sense to hire employees. If you bring in associates, they will work their way up to partner and that is where a lot of value comes in.

If you have a law practice that has ongoing recurring customers it is a lot more valuable. If it is just you and a shingle, but your clients are more one time only (like, say, consumer bankruptcy) then your client files aren't worth a lot and your name can only stay with the business as long as you do.