Entrepreneurs – The Paradox of Investing Outside of Your Business

By Michael Torney, CFP, J.D., LL.M. 

Most entrepreneurs have a single focus – working to make their business successful until it is generating steady profits. To achieve that goal, they often invest 100 percent of their annual profits back into the business. 

The strategy can have a number of benefits.  Yet, it often creates other problems. It doesn’t diversify the business owner’s wealth, making them completely dependent on the performance of the business.  It also leaves a business owner dependent on credit when times are hard.  Finally, it creates issues when selling the company because the founder’s entire retirement success is dependent on the sale price of the business.  Diversifying your wealth – in effect, spreading the risk – has some key advantages. 

I advise my clients who are entrepreneurs to annually reinvest some percent among 1) safe liquidity for the owner’s lifestyle needs; 2) a broad mix of pre-tax contributions in retirement plans, 3) after-tax contributions in brokerage accounts. This money is allocated among stocks and bonds that have historically provided steady growth.  

Having a few years of lifestyle expenses in safe assets (T-bills for example) provides a business owner with the ability to fund growth plans in the business more easily knowing if there’s a down year in profits, there’s cash to fund their lifestyle. 

Some entrepreneurs believe investing in the stock market is riskier than investing in the business – and it does come with risks.  Yet, that same entrepreneur will invest 100% of all their money into one company.  Money invested in a basket of thousands of companies has a different risk profile than one single business.  Being unfamiliar with a certain kind of risk (the market) doesn’t mean it is more risky than investing in the business – take some time to learn how the risks in the market compare to your business. 

Investing outside of the business not only can help generate wealth, but also can provide liquidity and the ability to receive quicker approval for loans to expand the business. 

Wealth generated by investments also provides flexibility for the future. Let’s say the business becomes successful and a prospective buyer would like to purchase your company.  Because of your outside assets, you may have additional negotiating power. If the prospective buyer’s bid is strong, you could decide to sell.  If not, you can hold onto the business and continue to grow it, or eventually sell as part of an Employee Stock Ownership Plan (ESOP).  

Here is a quick summary of a few investment vehicles available to entrepreneurs:

Traditional 401(k) Retirement Plan

This is a tax-deferred retirement account, which means the money you contribute is not taxed until you begin withdrawing it during retirement. As a business owner, you can contribute up to $66,000 in 2023 between employee and employer contributions. This amount increases to $73,500 for those who are 50 and older. 

A Simplified Employee Pension (SEP) Individual Retirement Account

A SEP IRA is an additional pre-tax retirement account option. Like a 401(k)-retirement plan, the money and the earnings from this account are tax-free until retirement. Te Secure Act 2.0 legislation has also added SEP Roth IRA accounts, funded with post-tax dollars. Contributions to a SEP in 2023 are limited to 25 percent of your compensation or $66,000, whichever is less. 

Traditional IRA or Roth IRA

A Roth IRA is an Individual Retirement Account to which you contribute after-tax dollars. A traditional IRA is the same account funded with pre-tax dollars (though sometimes nondeductible contributions are made depending on your annual income).  Retirement withdrawals from a Roth IRA can be tax-free while the traditional IRA is subject to ordinary income tax. There is generally a penalty (additional 10% tax) for withdrawals made before age 59½, though there are some exceptions. There are also multiple five-year rules to consider for distributions from a Roth IRA to be considered qualified distributions and avoid any penalty.  In 2023, one can contribute up to $6,500 between these two types of accounts and those 50 and older can contribute up to $7,500. 

A Taxable Brokerage Account

Unlike the retirement plans mentioned above, the earnings from this account are taxable. However, there is no limit to the amount you can invest, and funds can quickly be accessed if the business has an emergency expense.  

Making a decision to invest outside of your business can raise many questions. For help in answering your questions, contact our team at Duffteam@monetagroup.com. We work with many small business owners and offer a free consultation on how a comprehensive financial plan can help you and your business. 

 

© 2023 Advisory services offered by Moneta Group Investment Advisors, LLC, (“MGIA”) an investment adviser registered with the Securities and Exchange Commission (“SEC”). MGIA is a wholly owned subsidiary of Moneta Group, LLC. Registration as an investment advisor does not imply a certain level of skill or training. The information contained herein is for informational purposes only, is not intended to be comprehensive or exclusive, and is based on materials deemed reliable, but the accuracy of which has not been verified. 

Trademarks and copyrights of materials referenced herein are the property of their respective owners. Index returns reflect total return, assuming reinvestment of dividends and interest. The returns do not reflect the effect of taxes and/or fees that an investor would incur. Examples contained herein are for illustrative purposes only based on generic assumptions. Given the dynamic nature of the subject matter and the environment in which this communication was written, the information contained herein is subject to change. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. An index is an unmanaged portfolio of specified securities and does not reflect any initial or ongoing expenses nor can it be invested in directly. Past performance is not indicative of future returns. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise 

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