Small Businesses, Big Opportunities: A Retirement Planning Primer for Consultants and Small Business Owners

Owning and managing a consulting practice or other small business is hard – rising health care costs, competitive threats, reducing taxes and ensuring retirement savings are among the difficult issues. On top of that, the research firm Manta crystallized perhaps one of the hardest parts of all. In 2017, Manta surveyed nearly 2,000 small business owners about their retirement planning philosophies and activities. The study found that more than one-third had no retirement savings plan whatsoever and another 36 percent were planning to find new jobs after “retiring” from their businesses.

It’s a stressful balancing act for entrepreneurs – managing the cash flow needs of the business while saving money to meet their long-term personal financial goals. They need to live with one foot in the present to maximize opportunity and one foot in the future to secure the retirement they always dreamed of.

Sound retirement planning – goal-oriented, strategic, thoughtful and timely – can help them find that elusive balance point, which includes an invaluable means of employee retention. But retirement plans – like small business owners – come in a million different shapes and sizes. Finding the right match requires a thorough exploration of everything from goals and assets to risk tolerance and investment vehicles. We’ve crafted four hypothetical scenarios that blend a variety of our client profiles.* See if one aligns with your own situation, and connect with an advisor at Foster & Motley to start building your retirement planning approach from there.

The Case of the Ambitious Radiologist

Dr. Williams is a 54-year-old radiologist who stays very busy. He’s on staff at one of the city’s largest hospitals and also works as an independent consultant. The hospital offers a 401k, within which Dr. Williams maxes out his contributions. His consulting work is run through a limited liability corporation (LLC), and the doctor contributes the maximum 25 percent of his 1099 consulting income to a SEP IRA that he set up when he first started moonlighting. Let’s look at his holdings.

Whether it’s a 401k or 403b, an employer-sponsored plan comes with more paperwork for the administrator but is simple for the participant. It also allows for significant contributions from both the employee and employer. Of his total W2 compensation, Dr. Williams is able to contribute up to 100 percent and the hospital can contribute up to 25 percent. Both the employee and employer contributions are subject to annual limits. Meanwhile, the doctor’s SEP-IRA is ideal as his supplemental savings vehicle. It’s easy to set up and contributions don’t reduce the total amounts allowed under other employer plans. Employer contributions can max out at the lesser of $56,000 or 20 percent of his consulting net income.

The retirement planning combination was designed specifically for Dr. Williams and syncs with his 5- and 10-year goals, his plan to stop working full-time at age 60 and his current cash flow needs. We’ve built similar plans for professionals in comparable scenarios – accountants, professors, and others who divide their work life into a traditional career (with an employee-sponsored plan) and freelance consulting (with non-W2 income).

A Small Business Thinking Big

Wright Corp. is a small business owned and operated by a small group of executives that have been together for a long time. The company finds itself in a scenario much like the one faced by thousands of businesses around the country – fewer than 100 employees, profitable, and looking to retain its top talent. Wright Corp. has 25 people, the majority of whom are high wage employees. We helped them set-up a 401k plan, subject to limits like Dr. Williams’ situation, and requiring tax filings and a third-party administrator. We also recommended a Safe Harbor plan, which needs some explanation.

To make sure everyone has a chance to benefit from the plan their employer offers, the IRS has set up a series of what it calls “nondiscrimination” tests that are designed to measure whether a 401k plan unduly favors highly compensated employees. If your plan were to fail one of these tests, it could mean making expensive corrections, a lot of administrative work, and potentially even refunding 401k contributions. A Safe Harbor plan is a special kind of 401k that is exempt from nondiscrimination testing. It has certain built-in elements that help all employees save by requiring companies to contribute to their employees’ 401k. When employers take this step to encourage more employees to participate, the IRS offers them “safe harbor” from both the nondiscrimination testing process and the consequences of failure.

OK, so with the 401k in place, we suggested two investment options:

The Adventures of Mr. & Mrs. Consultant

Chris and Madeline Schmidt started their own creative consulting business several years ago. It’s always been just the two of them, and they’ve never had any other employees. They are both in their early fifties and are enjoying the fruits of a lucrative growth strategy that has them in the midst of their highest income years. In fact, they just landed a profitable five-year client contract that gives them a very predictable (and significant) income track for the near future. They would like to retire after that contract expires in five years, but are pretty late to the game in terms of their retirement planning. The Schmidts started a 401k plan only three years prior, so most of their savings were in a joint investment account.

To catch up and leverage their high income window, the couple added a Defined Benefit Pension Plan (DBPP), a vehicle in which an employer/sponsor promises a specified pension payment on retirement that is predetermined based on the employee's earnings history, tenure of service and age, rather than depending directly on individual investment returns. The DBPP allows the couple to contribute up to $225,000 each year to the plan and roll it into an IRA at retirement.

DBPPs are most likely to be used by consultants, lawyers, accountants, doctors and closely held small businesses with few or no other employees and predictable cash flow. It’s a great way for those owners to save on taxes and quickly build a tax deferred account late in their careers. There are expenses with DBPPs – including attorney and actuary fees – but those costs are typically contained within a brief timeframe. A DBPP must cover all employees, so it was ideal for the Schmidts. It also must have stable cash flow, because contributions are required, and if the investments underperform, the employer must make up the shortfall. In this case, the Schmidts had stable cash flow from the new client contract to bank on.

At the end of the day, we knew the Schmidts couldn’t build their retirement fast enough within the 401k alone. We built a plan that would allow large investment amounts with the greatest tax deferral and a big payout at the end. Again, the solution matched their short and long-term goals, and gave them the peace of mind that comes with knowing your retirement years are financially secure.

In the Land of a Corporate Giant

Lisa Lynne was a 30-year engineer for a Fortune 500 company and ready to retire. She did well at the company, with strong salary increases and deferred compensation in the form of stock options that would mature over the next several years. Plus, she already had several part-time consulting assignments lined up as she began her semi- retirement. Like many professionals in her situation, Ms. Lynne’s biggest income years were about to come in the period right after retirement. That’s right – the combination of her new 1099 consulting income and stock options for the next five years would move her to the highest tax bracket. She needed to effectively defer taxable income, and she needed to chart a plan that would include her Fortune 500 profit sharing plan and other assets. So she funded an individual 401k with her consulting income.

Like Dr. Williams in our first story, Ms. Lynne was able to put 100 percent of her consulting income into the plan up to $25,000, which includes the $6,000 “catch-up” she’s allowed since she’s over age 50, and may have an opportunity for an additional employer contribution subject to annual limits. But unlike Dr. Williams, her plan was an Individual 401k – easy to set up and with a very mild ongoing administrative burden. She only needs to file a tax return (5500) when assets exceed $250,000 or the plan is terminated.

So Many Options

These four snapshots just scratch the surface. There are dozens of options that can be deployed to fit a multitude of work/life/retirement scenarios. There are Simple IRAs, for example, which can be used for self-employed people and small businesses that don’t want the expense of setting up a 401k with matching. We’ve seen them all and work with clients every day to help them navigate the retirement planning waters.

The first step is always the same. We’ll sit down and do a full discovery session – income streams and all their sources, prior years’ tax returns, the plans you’re currently in, what you’re deferring and how much, cash flow needs now and in the future, time left until retirement, life goals, and so much more. Then we’ll deliver customized recommendations that fit your situation. Owning and managing a small business is hard. Retirement planning doesn’t have to be.

* Disclaimer: These scenarios are hypothetical in nature, for illustrative purposes only, and should not be considered investment advice. The information is intended to illustrate services available at Foster & Motley, Inc, and is not intended as a testimonial or endorsement of Foster & Motley, Inc. as an investment advisor. The scenarios do not necessarily represent the experiences of other clients, does not reflect actual investment results, nor is a guarantee of future results. The investment strategies discussed are not appropriate for every investor and take into consideration a client’s investment objectives and financial needs. Clients should review with their Foster & Motley, Inc. Financial Advisor the terms, conditions and risks involved with specific services and products.

Retirement Planning

Small Business Retirement Planning

with advice from a Cincinnati based
401k management company

Authors: Paul Staubach, CPA, CFP® &
Thom Guidi, CFA