Small business owners face a unique, but critical investing challenge: diversifying investment holdings outside of the business. For business owners, diversifying your sources of wealth takes on added importance. Focusing too much on your business could leave you exposed in the event of an economic downturn or some other change in circumstances.
Luckily, there are many options to consider that can help diversify the wealth you have earned. Earmarking funds for retirement, using a trust to bequeath your legacy to heirs, and/or broadening your investment mix may be helpful in reducing reliance on your business.
Earmark Assets for Retirement
A small-business retirement plan may help an entrepreneur divert a portion of salary for use in his or her later years. Plans with high contribution limits, such as a 401(k) plan, may be especially helpful in this regard. If your business elects to sponsor a 401(k) plan, traditional and Roth-style plans present different types of tax benefits. Contributions to traditional 401(k) plans are tax deferred, which lowers taxation during the year the contribution is made. After age 70½, required minimum distributions (RMDs) are taxable as income in the year distributed. Contributions to Roth 401(k) plans are made with after-tax dollars, but RMDs during retirement are generally tax free.1
Entrepreneurs with the means to invest for retirement above and beyond an employer-sponsored plan may want to consider a Roth IRA. With a Roth IRA, the maximum annual contribution for the 2017 tax year is $5,500, plus an additional $1,000 catch-up contribution for those aged 50 and older. To contribute the full amount allowed, your modified adjusted gross income (MAGI) needs to be $118,000 or less if you are a single taxpayer or $186,000 or less if you are married and filing a joint tax return (in 2017). Contributions are taxable, but qualified distributions after age 59½ are tax free. RMDs are not required from Roth IRAs during your lifetime, which enhances their appeal as an estate planning vehicle. If you desire, you can leave the assets in a Roth IRA and pass it to your heirs, income-tax free as an inherited Roth IRA when you are gone.
Leaving a Legacy
As you age, estate planning is likely to become increasingly important. A trust can help you maintain control of assets during your lifetime, shield assets from taxes, and create a legacy for heirs. There are many types of trusts, and your ultimate selection may depend on whether you want the trust agreement to be revocable or irrevocable. Depending on the type of trust selected, a trust agreement can make it possible to use life insurance proceeds income- and estate-tax free, to remove your residence from your estate, to bequeath assets to grandchildren, or to capitalize on a low-interest-rate environment and potentially reduce estate taxes. You should discuss the many trust options available with your tax or legal advisor.
Your Investment Mix
When managing investments, the old saying about not putting all your eggs in one basket is especially important for entrepreneurs. Exposure to equities, fixed income, real estate, and other types of assets can potentially help to diversify your investment mix and protect the wealth you have accumulated. Although there are no guarantees, if one area within your portfolio declines in value, another could potentially increase or hold steady, possibly reducing your exposure to loss. This strategy of balancing asset classes and diversifying your holdings is known as Modern Portfolio Theory. When implemented correctly and tailored to your individual risk tolerance, this strategy can help you achieve returns market rate returns in a conservative portfolio that also allows downside protection.
To truly diversify when investing, small business owners need to think outside the business. Reach out to a financial advisor that will work with you to help define an overall investment strategy that is in line with your goals and objectives.
1Early withdrawals may be subject to a 10% penalty tax in addition to regular income taxes on any investment earnings.