GPS For Retirementville

Is the business saleable?
One common exit strategy is for business owners to sell their business and use the resulting revenue for retirement. In fact, there can be some very tax-advantaged ways to structure the buy-out to significantly reduce the tax costs and even spread them out over time. On the surface, this might seem like a logical solution; however, it can bring with it a host of problems. In essence, owners who adopt this strategy are risking the possibility of discovering that their business is not as saleable as they thought it was, or that the business is not worth enough to adequately fund their retirement. Of course, these are not the only risks. There is also the possibility that the company could fail entirely. Additionally, another inherent risk is that business owners also have a tendency to see their business (and their sweat equity) as being worth far more than an outsider might. This can leave the business owners with a considerable gap to fill when their business doesn’t realize as much on the open market as they would have thought.

In other cases, owners may not be able to count on a revenue stream from the sale of their business. Very often in closelyheld companies, the owners wish to pass the business along to their children, and in some cases, often at far less than fair market value.

When business owners seek to pass their business on to their children, another common problem that occurs is they want to continue to draw income from the business, even after they have long since stopped working in it. Unfortunately, family members don’t often see eye-to-eye regarding this expectation and conflicts can arise. Of course, depending on the cash flow in the business, this may not even be possible. Generally speaking, it may often take hiring a new employee to help replace the work formerly done by the retiring business owner and so the cash flow that was once previously available may now be significantly depleted.

In family situations like those mentioned, business owners need to examine other options to fund retirement. Such options usually involve tax-deferred plans, such as 401(k)s, IRAs and SEPs.

Tax-deferred investments
Many financial advisors see tax-deferred vehicles as the cornerstone of a sound retirement strategy. There are two main reasons for this. The first is the consideration of the time value of money. Quite simply, this means that by using a tax-deferred investment, an individual is able to invest money that would have otherwise been paid to the government in taxes. In other words, instead of investing $70 and paying $30 in income tax (assuming a 30 percent tax bracket), an individual is able to invest the entire $100. This amount will then generate a higher investment return and thus, grow faster. When this effect is extrapolated over a period of years, the tax-deferred investment vehicle becomes an incredibly powerful tool.

The second primary consideration for a tax-deferred investment involves the tax deferral itself, which, in essence, refers to the likelihood that the investment will ultimately be subjected to tax at lower tax rates. The reason for this argument is that at retirement, most individuals are not at their highest earning capacity. Consequently, by deferring taxes until retirement an individual will, in nearly all cases, be paying taxes on a reduced income and be in a lower tax bracket, thereby netting more after-tax dollars than if the money was taken into income when in a higher tax bracket.

For example, an individual who—during his or her highest earning capacity—is making $200,000 per year, may be in the 33-percent tax bracket. This means that any additional income that is not deferred to a future year would be subjected to tax at a 33-percent tax rate (assuming just the federal tax brackets and that the individual is married). At retirement, this same individual is more likely to be on a fixed income, with social security and other benefits. If we assume, for the sake of argument, that this individual’s income drops to $60,000 after retirement (which is not a stretch), that same person would now be in the 15- percent tax bracket. This is a change of 18 percent in his federal tax rate. Obviously in this example, $100,000 of income deferred to retirement would save $18,000 in taxes in the year of withdrawal.