The biggest pitfall is the fact that it is usually all taxable and can wreak havoc on social security taxability and medicare premiums in retirement as unintended consequences. If it is market-based retirement asset, the second problem is the ultra-low distribution rate you are forced to live with to avoid the perils of systematic withdrawal risk and the fear of running out of money in 30-40 years. There are ways to fix this through careful pre-retirement planning that has the potential to increase your income by 30% to 50%, with no additional out-of-pocket expense, without increasing risk and guaranteeing more of your retirement income.
Sorry for the lengthy post, but this is a subject near-and-dear to me being the child of a business owner who didn't get the right advice. Loving this question, and surprised nobody's mentioned a few key factors yet.
A lot of the "didn't do" answers here are spot on - not enough planning, lack of understanding regarding business valuation, overly optimistic retirement dates (70-75+), no succession plan including structuring the entity (simply saying "my child will take it over" doesn't count) are all true. In my humble opinion, here are the top four reasons (in order):
Bad advice - This is at the tippy top of the list simply because very few business owners are familiar or comfortable with these topics. They will turn to someone else for guidance, which means they should already be aware of these things if they're working with a knowledgeable financial advisor - the problem here is that very few financial advisors are qualified to answer all of these questions, yet many of them will provide an unqualified opinion to avoid losing a client (or potential client). Some only have products to sell, and so their advice will very likely steer the client in the direction of whatever gets the advisor paid, i.e. permanent life insurance ("Tax-Free Retirement Savings!"), annuities
("Tax-Free Retirement Savings and Guaranteed Income!!"), plain vanilla 401k plans outsourced to a third party (no customization, potential for excessive fees, and limited owner contributions of <=19,500 + catch-up vs. the full IRS allowed employer + employee contribution of 58,000 + catch-up), SEPs/Simple IRAs, etc (cost to contribute can be too high with employees due to matching requirement; they also have contribution limits) which can result in very limited owner contributions to the plan or very high labor costs. Also, a broker can manage retirement funds in a SEP/Simple IRA without having to sign on as an ERISA fiduciary, which is how business owners delegate their fiduciary duty to employees in a retirement plan to a 3rd party expert. In truth, for small business owners 401k's and pensions are extremely viable retirement savings vehicles when structured properly, allowing business owners the opportunity to save up to $100,000+ per year leading up to retirement depending on their circumstances. I've seen other advisors push significantly more expensive and less practical solutions simply because they didn't want to deal with the liability of being the investment advisor to an ERISA plan (401k/pension), their broker/dealer wouldn't allow it, or they only sell insurance. See additional notes on taxes and cost of insurance below.
Not having a "life after" plan - without having a clear picture of what the owner will be doing with their lives after leaving their business, they won't have the motivation to do any of the things mentioned here. If they're associating leaving their business with negative emotions rather than excitement, good luck getting them to do anything.
Overly optimistic estimates of sale proceeds - different businesses have different values, and almost every owner estimates the value of their business to be significantly higher than the realized sale price. They mistake strong cashflows associated with a "lifestyle business," which most businesses are, with a high business valuation. If someone has to replace you as the rainmaker in the business in order to make the purchase succeed, expect a significantly lower sale price. They also fail to consider how taxes will impact the cash they receive after sale.
Lack of planning - without having a clear picture of what a realistic sale price is or what their actual needs in retirement are, business owners often hit huge speedbumps in the sale process. Because they don't actually know how much they need to retire comfortably, they demand an unrealistic sale price as their security blanket which can kill the deal. Instead, owners should be looking at the prospect of a sale and considering the factors listed above much earlier (10+ years). This allows them time to actively work on increasing the value of their business and plan for retirement before they burn out or the game of life forces their hand.
Because most business owners discover these answers too late, there's not much they can do about it other than accept the outcome, extend their retirement date to work on an exit with a higher sale price, or work until they can't anymore. Planning in advance provides options for growing your business into an exit, structuring your business for an optimal sale from a tax perspective, "cleaning up" the financials before shopping for buyers, and diverting cashflow away from the business to build diversified assets and fund a retirement nest egg separate from their business.
As promised, here are some additional resources for owners to consider:
Medicare premiums average out to about 1% of income for very high earners - the fees of using insurance as a savings vehicle could easily exceed the savings on insurance premiums, plus you're accelerating tax payments on the income used to fund the policy vs. deferring it:
Benefits Planner: Retirement | Medicare Premiums | SSA
Commissions can constitute a significant portion of total premiums paid into insurance, depending on the product and the carrier. There is certainly a place for insurance when doing planning for individuals and business owners, but the retirement use is far less applicable than estate planning, business continuity, providing for unfunded family needs, etc. unless you're making mid/high six-figure income annually and have a lot of employees:
Life Insurance Agents and Commissions: What to Know - NerdWallet
Lack of true diversification. Business owners at times do a great job reinvesting in their business and growing it but have limited outside investments. If they do have investments outside their primary business they often do not diversify into a proper mix of qual and non-qual account types. Not diversifying into multiple account types severely limits their tax planning ability in retirement. If they do have a good mix of account types they often think they are diversified with 15 different mutual funds or ETF's. Diversification here only happens with non-correlation of the investment mix into things like stocks, bonds, real estate, alternatives, fixed products AND their business.
Not taking care of themselves. Most business owners are so busy taking care of cash flow, employees and clients, they often do not slow down to look forward to see where they are going on a retirement time line.
The biggest pitfall we see with business owners and their respective retirement plans really falls into two buckets:
1 - Retirement Trajectory - are you assets being managed properly for the amount of time you have left to work before retiring. There in, are you saving enough every month and are you taking on too much or too little risk with those savings/investments to reach your end game goal.
2 - Selection of Retirement Vehicle - are you using the best type of investment for you and your business. There are a variety of investment options, some of which may make more sense than others for you. Using the right type of retirement vehicle could mean the difference between an owner being able to save an extra $30k+ pretax annually in a tax deferred investment.
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Answers (1-10)
The biggest pitfall is the fact that it is usually all taxable and can wreak havoc on social security taxability and medicare premiums in retirement as unintended consequences. If it is market-based retirement asset, the second problem is the ultra-low distribution rate you are forced to live with to avoid the perils of systematic withdrawal risk and the fear of running out of money in 30-40 years. There are ways to fix this through careful pre-retirement planning that has the potential to increase your income by 30% to 50%, with no additional out-of-pocket expense, without increasing risk and guaranteeing more of your retirement income.
Sorry for the lengthy post, but this is a subject near-and-dear to me being the child of a business owner who didn't get the right advice. Loving this question, and surprised nobody's mentioned a few key factors yet. A lot of the "didn't do" answers here are spot on - not enough planning, lack of understanding regarding business valuation, overly optimistic retirement dates (70-75+), no succession plan including structuring the entity (simply saying "my child will take it over" doesn't count) are all true. In my humble opinion, here are the top four reasons (in order):
Bad advice - This is at the tippy top of the list simply because very few business owners are familiar or comfortable with these topics. They will turn to someone else for guidance, which means they should already be aware of these things if they're working with a knowledgeable financial advisor - the problem here is that very few financial advisors are qualified to answer all of these questions, yet many of them will provide an unqualified opinion to avoid losing a client (or potential client). Some only have products to sell, and so their advice will very likely steer the client in the direction of whatever gets the advisor paid, i.e. permanent life insurance ("Tax-Free Retirement Savings!"), annuities ("Tax-Free Retirement Savings and Guaranteed Income!!"), plain vanilla 401k plans outsourced to a third party (no customization, potential for excessive fees, and limited owner contributions of <=19,500 + catch-up vs. the full IRS allowed employer + employee contribution of 58,000 + catch-up), SEPs/Simple IRAs, etc (cost to contribute can be too high with employees due to matching requirement; they also have contribution limits) which can result in very limited owner contributions to the plan or very high labor costs. Also, a broker can manage retirement funds in a SEP/Simple IRA without having to sign on as an ERISA fiduciary, which is how business owners delegate their fiduciary duty to employees in a retirement plan to a 3rd party expert. In truth, for small business owners 401k's and pensions are extremely viable retirement savings vehicles when structured properly, allowing business owners the opportunity to save up to $100,000+ per year leading up to retirement depending on their circumstances. I've seen other advisors push significantly more expensive and less practical solutions simply because they didn't want to deal with the liability of being the investment advisor to an ERISA plan (401k/pension), their broker/dealer wouldn't allow it, or they only sell insurance. See additional notes on taxes and cost of insurance below.
Not having a "life after" plan - without having a clear picture of what the owner will be doing with their lives after leaving their business, they won't have the motivation to do any of the things mentioned here. If they're associating leaving their business with negative emotions rather than excitement, good luck getting them to do anything.
Overly optimistic estimates of sale proceeds - different businesses have different values, and almost every owner estimates the value of their business to be significantly higher than the realized sale price. They mistake strong cashflows associated with a "lifestyle business," which most businesses are, with a high business valuation. If someone has to replace you as the rainmaker in the business in order to make the purchase succeed, expect a significantly lower sale price. They also fail to consider how taxes will impact the cash they receive after sale.
Lack of planning - without having a clear picture of what a realistic sale price is or what their actual needs in retirement are, business owners often hit huge speedbumps in the sale process. Because they don't actually know how much they need to retire comfortably, they demand an unrealistic sale price as their security blanket which can kill the deal. Instead, owners should be looking at the prospect of a sale and considering the factors listed above much earlier (10+ years). This allows them time to actively work on increasing the value of their business and plan for retirement before they burn out or the game of life forces their hand.
Because most business owners discover these answers too late, there's not much they can do about it other than accept the outcome, extend their retirement date to work on an exit with a higher sale price, or work until they can't anymore. Planning in advance provides options for growing your business into an exit, structuring your business for an optimal sale from a tax perspective, "cleaning up" the financials before shopping for buyers, and diverting cashflow away from the business to build diversified assets and fund a retirement nest egg separate from their business.
As promised, here are some additional resources for owners to consider:
Social Security is 85% taxable for most people earning a decent income in retirement, using permanent insurance makes little difference - if you can afford it, you're making enough that you're probably paying the taxes on 85% anyways: Don’t forget, Social Security benefits may be taxable | Internal Revenue Service (irs.gov)
Medicare premiums average out to about 1% of income for very high earners - the fees of using insurance as a savings vehicle could easily exceed the savings on insurance premiums, plus you're accelerating tax payments on the income used to fund the policy vs. deferring it: Benefits Planner: Retirement | Medicare Premiums | SSA
Not aware of any passive income back-taxes that are different from the normal tax code - it can, however, result in a tax rate that's lower than your ordinary income tax rate. Knowing the Tax Differences Between Active and Passive Income - Business 2 Community
Commissions can constitute a significant portion of total premiums paid into insurance, depending on the product and the carrier. There is certainly a place for insurance when doing planning for individuals and business owners, but the retirement use is far less applicable than estate planning, business continuity, providing for unfunded family needs, etc. unless you're making mid/high six-figure income annually and have a lot of employees: Life Insurance Agents and Commissions: What to Know - NerdWallet
I am assuming you are discussing an incorporated business. Sole proprietorship is a whole different issue. For incorporated business:
- failure to structure ownership for ownership to be passed on to another family member
- not arranging for interest to be bought out by other shareholders
- not getting an independent evaluation of business value
- not getting a Unanimous Shareholder Agreement that addresses this event
I would say two things:
Lack of true diversification. Business owners at times do a great job reinvesting in their business and growing it but have limited outside investments. If they do have investments outside their primary business they often do not diversify into a proper mix of qual and non-qual account types. Not diversifying into multiple account types severely limits their tax planning ability in retirement. If they do have a good mix of account types they often think they are diversified with 15 different mutual funds or ETF's. Diversification here only happens with non-correlation of the investment mix into things like stocks, bonds, real estate, alternatives, fixed products AND their business.
Lack of a business succesion plan
Miscalculation of their time horizon
Not taking care of themselves. Most business owners are so busy taking care of cash flow, employees and clients, they often do not slow down to look forward to see where they are going on a retirement time line.
avoiding Receiving the same canned email from every insurance piker on the planet just like you
The biggest pitfall we see with business owners and their respective retirement plans really falls into two buckets:
1 - Retirement Trajectory - are you assets being managed properly for the amount of time you have left to work before retiring. There in, are you saving enough every month and are you taking on too much or too little risk with those savings/investments to reach your end game goal.
2 - Selection of Retirement Vehicle - are you using the best type of investment for you and your business. There are a variety of investment options, some of which may make more sense than others for you. Using the right type of retirement vehicle could mean the difference between an owner being able to save an extra $30k+ pretax annually in a tax deferred investment.