How Long Is Your Runway? Establishing a Cash Reserve When Starting a Business

Starting a business involves a great deal of risk.  You’ve probably run across this statistic from the small business administration before: 30% of new businesses fail in the first 12 months of operations.  50% fail in the first 5 years, and 66% fail in the first 10.  The odds are not terribly good that a new venture will grow into a viable company.

For many businesses that do end up failing, the problem usually isn’t that there’s no market for new product or service and the founder’s idea doesn’t work.  The problem is that the founder runs out of money.  I’ve heard the story at least a dozen times: entrepreneur quits a stable job to start a new business.  Their objective is to make the new venture profitable enough to fund their living expenses before their savings run out.  It takes a little longer to get up and running than initially thought, and their savings accounts falls to dangerously low levels.  They can’t hold out any longer, and are forced to cease operations, take a step back, and find a job that offers a steady income.

The amount of cash you have in the bank is commonly known as your “runway”.  The longer your runway, the more likely a business will succeed.  So how long should your runway be, exactly, when starting a business?  If you’re about to take the leap into entrepreneurship, these are the exact steps I’d take to figure that out.

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A Beginner's Guide to Cash Balance Plans

A Beginner’s Guide to Cash Balance Plans

In my financial planning practice I work with a good number of business owners who want to make aggressive contributions to their tax deferred retirement accounts.  This helps put them on strong footing for retirement, but also provides a generous tax deduction.  While the 401k plan is the primary retirement plan most business owners are familiar with, a cash balance plans is one I often recommend in addition.  In fact, cash balance plans can actually allow for far greater contributions & tax advantages.

A cash balance plan could be a good fit if you’d like to contribute over $50,000 per year to a tax advantaged retirement plan.  They don’t come without their nuances though.  This guide will explain how cash balance plans work and whether they might be a good fit for you.

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It's Never too Early to Start a Succession Plan

It’s Never Too Early to Start a Succession Plan

So here’s a topic that all business owners have thought about but few have taken action on: succession planning.  I was reading a study by Wilmington Trust the other day that polled 200 different owners of privately held businesses.  Personally, I’ve yet to meet a business owner who doesn’t agree that succession planning is important to their company and stakeholders.  Yet in this study, 58% of the businesses polled don’t have one in place!

Successions impact…everything: your family, your legacy, your finances, your employees, your partners, your customers, your stakeholders, and anyone else who touches your company.  My guess is that you want all these pieces intact throughout your transition and after you leave.  Yet most business owners don’t tackle the issue until a) it’s high time to exit, or b) they’re forced to for a reason out of their control.

Why?  Many people start to realize that the emotions involved are heavy and deep.  Your business is probably something that you’ve poured your heart and soul into for a long period of time.  You may have taken significant financial risks that have impacted your family along the way.  The decision making required in succession planning brings up a lot of emotion, and many business owners prefer to kick the can down the road rather than deal with them.

Problem is, there are many situations out of our control that could force a succession at an inconvenient time.  Health problems, car accidents, or even changes in the economy or your industry could easily force your hand.  Rather than rush into a transition unprepared (and in a potential fire sale), you’ll reach a far more desirable outcome when your succession is planned for.  What happens if you get into an accident and come out with diminished mental capacity?  What happens if you have a heart attack & die tomorrow?  What’s the game plan?  Who will step in, and how will your family, employees, customers, and other stakeholders be taken care of?  These are the questions a good succession plan answers.  They’re also the questions that must be made while you’re in a calm, stable, and clear state of mind.

 

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Investing in Yourself as an Entrepreneur

Investing In Yourself as an Entrepreneur

Many of us feel an innate need to make contributions to tax advantaged retirement plans every year.  When it comes to personal finance, much of what we read, hear, and see in the media centers on plowing money into your 401k every single year, no matter what.

In general it’s great advice.  Save early and often, and take advantaged of tax deferred compound income.  And if you’re lucky, your employer might match your contributions or make a profit sharing contribution.  If we’re going to build up enough savings to sustain our lifestyle through retirement, this makes perfect sense.

Every once in a while I’ll speak with an entrepreneur who is really working hard to build their business, but they can’t quite scratch together enough cash to fund their retirement plan for the year.  They’re putting all their effort into their company and things are still just a bit tight financially.  They feel like they should be contributing to the 401k they set up for themselves and their employees, but they can’t quite pull the funds together to do so.

For many business owners I speak with, the fact that they can’t fund their 401k for the year makes them feel inadequate.  Like they’re not good at their job.  Like they’re unsuccessful.

I wanted to write a post on this topic because entrepreneurs who feel this way are missing the forest from the trees.  Regardless of whether you contribute to a retirement plan in a certain year, it’s far more important to sustain & grow your business.  Because if you can find a way to grow your business each year, the increased value in your ownership stake will dwarf what you could ever contribute to 401k!

 

It’s OK to Skip a Few 401(k) Contributions

Aswath Damodaran is a professor at NYU who teaches corporate finance, investing, and business valuation.  He publishes estimates of EBITDA multiple benchmarks for use by his students, and anyone else who’s interested.  EBITDA is an accounting measure that stands for “earnings before interest, taxes, depreciation, or amortization”.  It’s a decent proxy for free cash flow, and is often used in quick and dirty business valuations.

For example, let’s say your business does $350,000 in revenue one year.  If your costs & operating expenses totaled $250,000, you’d be left with EBITDA of $100,000.  Here are Professor Damodaran’s valuation estimates for 2018.  The list of multiples ranges from 5-6x EBITDA on the low end to nearly 20x on the high end.  Meaning, it’s very possible that a business with $100,000 in recurring annual EBITDA is worth at least $500,000 ($100,000 * 5).

Now, when I mean quick and dirty, this example is very quick, and very dirty.  Business valuation is a field of its own, and not something I claim to be half way competent in.  There are a ton of factors that go into what a business is worth, and EBITDA certainly doesn’t paint the whole picture.  Nevertheless, the takeaway is important: if you can build a business with recurring annual revenue, that will persist even if you’re not around to drive sales, there’s a good chance you’re creating far more wealth than what you would maxing out your 401k contributions.

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Should Your Portfolio Change After You Retire?

Should Your Portfolio Change After You Retire?

One question that’s come up several times over the last couple months centers on whether your portfolio should change after you retire.  In fact, one person I’ve spoken with recently assumed that once he retired, his advisor would by default sell all the stock funds in his accounts and replace them with income producing bonds.

Typically the longer your time horizon, the more risk you have the capacity to take in your investment portfolio.  Most people in their 20s and 30s have a high capacity to take risk, since they have a long time until they’ll need to live off their savings.  A significant portfolio loss won’t impact their life, and they have a long time to recover.  Because of that, many choose to hold mostly equities in their retirement accounts since they’ll provide the greatest long term returns.

The closer you get to retirement, the lower your capacity to take risk.  Prudent investors tend to shift their asset allocations more and more toward bonds as this progression evolves.  But for most people it should level out at some point.  Most of us will need some growth out of our portfolios in retirement if our assets are going to last the rest of our lives, meaning that we probably don’t want to be 100% in bonds.

But how should our investment strategy change when transitioning from the accumulation to the distribution phases of our lives, and should it change at all?  This post will explore the issues, and what you might consider when making the transition yourself.

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Breaking Down the Industry for Financial Advice

Breaking Down the Industry for Financial Advice

The industry for financial advice is confusing.  Professionals in the business of helping the public with their personal finances work for different types of companies, are compensated in different ways, and have varying standard by which they’re required to treat their clients.

This is my 13th year in the industry.  Though my experience probably gives me more knowledge than the average consumer, there are quite a few I’m confused by all the layers at play.  (Yeah yeah, there’s a joke to be made there).  Whether it’s my cognitive abilities or whether the industry is in fact confusing, this post will attempt to break down & describe the industry for financial advice.  I’ll split this up into a few statistics, how advisors are compensated, one of the major problems this structure creates, and how you might interview an advisor you’re considering.

 

The Numbers

There are a lot of financial professionals in the United States.  FINRA (Financial Industry Regulatory Authority), is the national organization that keeps track of advisor licensing and currently lists about 630,000 representatives registered to deliver financial advice.  Now, many of those are not in the direct business of financial advice.  They may be investment bankers, they may be operational staff, and they may be running narrow products and services like managed futures or commodities strategies.  None of these are what I’d consider to be in the business of providing financial advice or planning services.

Cerulli Associates is a research company that does a much better job putting a finger on the actual number of people delivering some type of financial advice across the country.  Their most recent study estimated about 311,000, which includes professionals across all industry channels.  Of those 311,000, only about 50% deliver financial planning services.  Meaning, there are more or less 155,000 financial professionals in the US directly delivering advice and planning services.  This seems surprisingly low to me, given that there are about 125 million households across the country.  That means that if only half of the households in the US worked with a financial planner or advisor, each advisor would need to serve over 400 households!

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What You Need to Know About the SECURE Act Retirement Bill

What You Should Know About the SECURE Act Retirement Bill

Every now and then, lawmakers in Washington make noise about changing various sections of the tax advantaged retirement accounts I’m so fond of recommending to my clients.  Now that we’re living substantially longer, and a greater portion of our lives is actually spent in retirement, there’s a good argument that we should increase age limits, mandatory distributions, and other rules governing IRAs, 401(k)s and other types of accounts.

I usually don’t pay much attention to this speculation until there’s a bill on the floor that has a strong chance of becoming law.  The majority of the legislation drafted in this area doesn’t get far, and often doesn’t even get out of committee.

Nevertheless, the house and senate have both recently introduced bills that would change how retirement accounts work.  I’m no political expert, and don’t have the foggiest idea what the chances are of one of these bills passing.  But from what I’m reading there’s more momentum for retirement reform now than there’s been in the last several years.  Plus, more than one client asked my thoughts on the subject recently so I felt a summary post would be appropriate.  This post will cover what happened & why it might be important to you.

 

Pending Legislation

In February the senate introduced a bill called the “Retirement Enhancement and Savings Act” (or RESA), aimed at fixing America’s retirement savings problems – both in the public and private sectors.  This isn’t the first bill on retirement reform that’s been introduced recently.  Multiple versions containing similar provisions have been introduced since 2016, which speaks to the growing interest in helping Americans save for retirement.

Meanwhile, the house passed the SECURE Retirement bill (Setting Every Community Up for Retirement Enhancement Act) about a week and a half ago in a 417-3 vote.  This bill contains many of the same provisions as RESA, and the bipartisan support on both sides of congress could mean one of the bills may actually make it into law sometime soon.

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Maximizing Your 199a QBI Deduction as a Specialized Service Business

Maximizing Your 199a QBI Deduction as a Specialized Service Business

As you’re probably aware, we’re working with some new tax laws as of January 1st, 2018.  The tax change that will have the most impact for many business owners out there – particularly owners of pass-through businesses – lies in section 199a.

Section 199a specifies that qualified business income is eligible for a 20% across the board deduction on the owners’ personal tax returns.  20%!  This is a big deduction, and falls in line with all the political rhetoric about making the country a more business friendly environment.

Unfortunately, not every business owner will be able to claim it.  One of the more controversial aspects of section 199a is that the deduction phases out at certain levels of taxable income, if your business is considered a “specialized service business” (SSTB).  In 2019, this phaseout range is $315,000 to $415,000 of taxable income for married people filing jointly, and $157,500 to $207,500 for everyone else.

What exactly is a specialized service business, you ask?  It’s one whose principle asset is the skills or experience of one or more professionals.  This includes medicine, law, accounting, financial services, athletics, and several others.

With the introduction of section 199a & the QBI deduction, there are a number of tax planning opportunities for business owners.  Qualifying for the deduction and maximizing its benefit could easily have a significant impact on business owner’s total tax liabilities.  This post will explore three different types of tax planning strategies owners of specialized service businesses may consider to maximize the benefit of the 199a deduction.

 

Income Reduction Strategies

The first, most logical way to maximize the QBI deduction is to find ways to reduce your taxable income.  The lower you are in the phaseout range, the greater portion of the deduction you’ll qualify for.  Note here that the phase out isn’t based on your adjusted gross income or modified adjusted gross income (which is common for most other phaseouts, like IRA/Roth IRA contributions).  The QBI deduction phases out based on your taxable income, which is after you take itemized or standard deductions.  Here are a couple ideas to consider.

 

Qualified Retirement Plan Contributions

Establishing & funding a qualified retirement plan is usually the low hanging fruit for owners of specialized service businesses.  The best plan structure and form for your situation will depend on a number of factors, of course.  And if you have employees, chances are you’ll need to make contributions on their behalf as well.

The usual suspects here are SEP-IRAs & solo 401(k) plans for those without employees, and 401(k) & profit sharing plans for those with employees.  You can also tack on a cash balance plan or defined benefit plan if you want to be aggressive (and are comfortable with mandatory contributions each year).  In either case, every dollar you contribute to a qualified retirement plan, both as an employee deferral or employer contribution, will be deductible.  And, of course, every dollar you deduct gets you one dollar closer to the beginning of the phaseout range.

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Setting Up a 401(k) to Take Advantage of the 'Mega' Back Door Roth Conversion

Setting Up a 401(k) to Take Advantage of the ‘Mega’ Back Door Roth Conversion

If you’re a personal finance nut you may have heard of a strategy called the “back door Roth IRA conversion.”  This maneuver essentially allows you to contribute money to a Roth IRA, even if your income is otherwise to high to make a direct contribution.  You make a non-deductible contribution to a traditional IRA, convert those funds to a Roth IRA, and presto!  You have cash in the Roth that won’t ever be taxed again.  While it seems like this is a glaring loophole in the tax code, Congress has endorsed the strategy in a conference committee report from the Tax Cut & Jobs Act.

But as great as it is to take advantage of Roth IRAs while you’re in high tax brackets, you’re still limited to the annual IRA contribution maximums of $6,000 per year (or $7,000 if you’re 50 or older).  The “Mega” back door Roth conversion is a similar strategy, but allows for up to $37,000 per year in additional Roth contributions using a 401(k) plan.

 

Why the “Mega” Back Door Roth Conversion Strategy Works

 

The Three Types of 401(k) Contributions

To start, let’s review the three types of contributions you could make to a 401(k) plan.  The first is the most common: your employee deferrals.  You can instruct your employee to defer funds from your paycheck and deposit them on your behalf into the company’s 401(k) plan.  Some plans allow you to make these deferrals on a Roth basis, and the limit in 2019 is $19,000 per year.

The second type of contribution is an employer contribution.  This is anything your employer puts into the plan on your behalf, and includes matching contributions, or contributions based on a percentage of your compensation or company profitability.  It may be subject to a vesting schedule, and is always made on a pre-tax basis.

The third, and widely unknown type of contribution is an after-tax deferral.  Some 401(k) plans allow you to make additional contributions beyond your employee deferral on an after-tax basis, once you’ve reached the $19,000 annual limit.  Note here that 401(k) plans are not required to allow this feature, and not all do.

There are two limitations to annual 401(k) contributions.  The first is the $19,000 limit on employee contributions ($25,000 if you’re over 50 years old).  The second is on the total amount contributed to the plan on your behalf.  This limit is $56,000 in 2019, and consists of the three contribution types listed above.

So, to determine how much you could contribute in after-tax deferrals, you’d need to subtract $19,000 (again, $25,000 if you’re over 50) and the total amount of your employer contributions from $56,000.

Theoretically you could make up $37,000 per year in additional Roth IRA contributions using this maneuver ($56,000 – $19,000).  You’d need to be under 50 though, and you couldn’t receive any contributions from your employer.

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A Review of Providence's 457(b) Plan

A Review of Providence’s 457(b) Plan

In my financial planning firm I work mostly with business owners and medical professionals.  A good number of my clients are employees of Providence, which is one of the major medical providers in the Pacific northwest.  Providence offers its employees a very strong benefits & retirement package.  Employees can contribute to a 403(b) plan on a tax-deferred or Roth basis and Providence contributes to a 401(a) plan on their behalf, depending on compensation and years of service.

Providence also offers a 457(b) plan to its employees.  While it’s convenient to have another tax-deferred savings vehicle available, 457 plans come with some quirks – especially surrounding distribution options once you separate from service.

Recently, one my of my clients and I discussed the possibility of them leaving to take another job.  So to wrap our heads around the ins and outs of the 457 plans, we jumped on the phone with one of Providence’s retirement plan administrators.  The administrator helped to explain the unique features of the plan, which I’ll explain in this post.  Hopefully this review is helpful to anyone thinking about participating in Providence’s 457 plan.

 

A Quick Primer on 457(b) Plans

457(b) plans are sometimes mistakenly considered an alternative to a 403(b) plan.  There is actually some nuance to 457(b) plans, and much of it depends on whether the plan is sponsored by a governmental entity.

457(b) plans sponsored by governments have nearly identical rules to 403(b) plans.  The contribution limits are the same, the distribution options & limitations are the same, and by and large the plans operate in the same way.

Non-governmental 457(b) plans are different, in several ways.  Whereas the contribution limits are the same, the distribution options are not.  For non-governmental 457(b) plans, you are not allowed to roll your balances into an IRA.  Yes, you read that correctly.  Whereas participants in government sponsored 457(b) plans may roll their balances into IRAs after separating from service without triggering a taxable event, participants in non-governmental plans may not.

Instead, as a participant in such a plan you’re limited to the unique distribution options of the plan.  This is worth some investigation, as some plans require full distribution shortly after separating from service.  There isn’t an early distribution penalty for withdrawals prior to age 59 1/2, but withdrawals are still taxed as income.  Think about that for a moment.  You participate in a non-governmental 457(b) plan for years, accumulating potentially hundreds of thousands of dollars in the plan.  Then when you separate from service you’re forced to take everything out, and be taxed on it, in one year.

Another unique difference is creditor protection.  Whereas 403(b) and 403(k) plans are held in trust, 457(b) plans are held in the name of the organization sponsoring the plan.  This seems like a subtle difference, but can be impactful in the event of liquidation.  If the sponsoring organization falls into bankruptcy, your assets in the plan would be exposed to creditors.  The chances of this happening are probably quite small (especially for an organization like Providence), but I’m sure that’s what everyone at WorldCom and Enron thought as well.

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