Prepared by: Kerry W. Pulliam, CFP, AEP, CEPA | Apogee Capital Resource Group, a Capitas Financial team
Email: Kerry.Pulliam@CapitasFinancial.com | Phone: 502-599-6623
For successful business owners, the business often represents their most significant asset and a primary source of wealth creation. While the dream of a lucrative business sale to fund retirement is compelling, the reality can be far more complex. As advisors, it's crucial to guide clients through a holistic diagnostic process – our "FLIGHT" path – to ensure their personal financial security isn't solely dependent on a single exit event.
Many business owners are exposed to significant concentration risk, with their personal wealth tied directly to the success and eventual sale of their company. What if the market isn't favorable for a sale? What if health issues force an earlier exit? What if the business doesn't command the expected valuation? These are critical questions that necessitate proactive planning for personal savings outside the business.
The Reality of Business Sales at Retirement
While many business owners plan to sell their businesses at retirement, the statistics highlight the challenges:
Low Success Rate: Only about 20% to 30% of businesses listed for sale actually sell. This means 70% to 80% do not. (Source: Exit Planning Institute, as cited by Raymond James and Teamshares
Lack of Planning: A significant percentage of business owners (nearly two-thirds of family businesses, for example) lack a documented succession plan. (Source: PwC's US Family Business Survey, as cited by Teamshares)
Overestimation of Value: Many owners overestimate their company's worth. A 2023 UBS study found that 48% of owners haven't had their businesses professionally valued. (Source: Raymond James )
Market Dynamics: Factors outside an owner's control, such as market downturns, declining industries, or a limited buyer pool, can significantly impact the ability to sell. For instance, high acquisition costs are a major barrier for buyers. (Source: BizBuySell Insight Report, as cited by Teamshares )
These realities underscore the critical need for business owners to build robust personal savings outside of their enterprise, providing the flexibility and freedom to retire comfortably, regardless of the business's ultimate exit outcome.
Navigating Retirement Plan Options: Qualified Plans, Roth IRAs, and Advanced Strategies
Let's examine common retirement savings vehicles and their suitability for business owners, keeping in mind the need for tax efficiency, liquidity, and asset protection.
F – Foundation of Knowledge: Understanding Core Retirement Vehicles
1. Qualified Retirement Plans (e.g., 401(k), Profit-Sharing Plans)
These plans offer significant tax advantages and are often a cornerstone of retirement planning due to their tax-deductible contributions and tax-deferred growth.
Advantages:
Tax-Deductible Contributions: Employer contributions are generally deductible, reducing taxable business income. Employee deferrals are pre-tax, reducing current personal income.
Tax-Deferred Growth: Investments grow without annual taxation.
Creditor Protection: Generally offers strong asset protection from creditors under ERISA.
Disadvantages:
Contribution Limits (Relative to UHNW/HNW Needs): While contribution limits can be substantial, for UHNW and HNW business owners looking to maximize personal savings, the statutory limits (e.g., $70,000 combined employer/employee for a 401(k) in 2024, not counting catch-ups) may not be sufficient to meet their aggressive wealth accumulation goals.
Cost and Complexity for Maximizing Owner Contributions: To maximize funding for the owner and key family members, these plans often require "Safe Harbor" contributions or must pass complex non-discrimination testing. This can significantly increase the cost, as the owner may need to contribute substantially to employee accounts to satisfy IRS rules. It can feel like "spending $3 to get $1" of benefit for the intended recipients (owner/key employees) due to the required contributions to a broader employee base.
Lack of Liquidity: Generally, funds are locked in until age 59½, with penalties for early access (10% additional tax, with some exceptions). This limits access to capital for business needs.
Required Minimum Distributions (RMDs): At a certain age (currently 73 for those born after 1949), owners must begin taking taxable distributions.
2. Regular Managed Investment Accounts
These are non-qualified accounts, offering flexibility but lacking the specific tax advantages and protections of qualified plans.
Advantages:
Liquidity: Funds are generally accessible at any time without age-related penalties.
Flexibility: Can be diversified across a wide range of asset classes.
Collateralization: Can potentially be used as collateral for business loans or lines of credit, offering a valuable source of capital when needed.
Disadvantages:
No Tax Deduction: Contributions are made with after-tax dollars.
Tax Inefficiency: Investment gains (interest, dividends, capital gains) are typically taxable annually. Rebalancing the portfolio can trigger capital gains taxes.
No Creditor Protection: Assets are generally not protected from business or personal creditors.
3. Roth IRAs
Often considered a "holy grail" for tax-efficient retirement funding due to their tax-free withdrawals in retirement.
Advantages:
Tax-Free Growth and Qualified Withdrawals: Contributions are made with after-tax dollars, but qualified withdrawals in retirement (after age 59½ and a 5-year holding period) are completely tax-free, including all earnings. Rebalancing within the account is also tax-free.
Penalty-Free Access to Contributions (Pre-59½): A key advantage for business owners is the ability to withdraw their original contributions at any time, for any reason, completely tax-free and penalty-free, regardless of age. This offers a valuable layer of liquidity for emergency needs or unexpected business opportunities.
No RMDs for Original Owner: Unlike traditional IRAs and qualified plans, the original owner is not required to take distributions during their lifetime, allowing for continued tax-free growth and flexibility for estate planning.
Disadvantages:
Contribution Limits: Annual contribution limits are relatively low compared to qualified plans ($7,000 in 2024, $8,000 if age 50+).
Income Limitations:Direct contributions are subject to Modified Adjusted Gross Income (MAGI) phase-outs, often excluding UHNW and HNW individuals.
Roth Conversions: While higher earners can utilize "backdoor" Roth conversions, these involve converting pre-tax IRA funds to Roth, which triggers an immediate tax liability on the converted amount.
Limited Early Access to Earnings: While contributions are always accessible, earnings are subject to taxes and penalties if withdrawn before age 59½ (unless a specific exception applies, and the 5-year holding period is met).
Cannot Be Collateralized: Roth IRA assets cannot typically be used as collateral for loans, limiting their utility for business capital needs.
No Upfront Tax Deduction: Contributions are made with after-tax dollars, so there's no immediate tax benefit.
L – Leverage Collaborative Team: The Power of Strategic Design
For the successful business owner, especially UHNW and HNW individuals, the limitations of traditional options become apparent. This is where advanced strategies, often involving a collaborative team of advisors (financial, legal, tax), become essential.
4. Cash Value Life Insurance (CVLI) Designs – A "Synthetic Roth"
For those who qualify and have sufficient capital, properly structured Cash Value Life Insurance (e.g., Whole Life, Universal Life, Variable Universal Life – VUL, or Private Placement Life Insurance – PPLI) can serve as a powerful supplemental retirement vehicle, often referred to as a "synthetic Roth."
Advantages:
No Contribution Limits: Unlike Roth IRAs, there are generally no IRS-imposed limits on how much premium can be paid into a properly structured CVLI policy, allowing for significant tax-advantaged savings.
Tax-Deferred Growth: The cash value grows on a tax-deferred basis, similar to qualified plans.
Tax-Free Access to Value (if structured properly): Policyholders can access the cash value through withdrawals up to basis and policy loans, which are generally income tax-free when structured correctly. This provides tremendous flexibility for supplemental retirement income or even business capital needs, without penalties, regardless of age.
Liquidity: The cash value offers a liquid asset that can be accessed at any time.
Collateralization: Policies can often be collateralized for loans, providing a valuable source of capital for business expansion or unexpected needs without liquidating assets or triggering taxable events.
Creditor Protection: In many states, the cash value and death benefit of life insurance policies offer significant, and sometimes unlimited, creditor protection, safeguarding personal savings from business risks or lawsuits.
Asset Class Diversification (VUL/PPLI): Variable policies (VUL/PPLI) allow investment across a broad spectrum of asset classes, similar to a brokerage account, with rebalancing occurring tax-free within the policy. PPLI, in particular, can offer access to institutional-grade alternative investments.
Death Benefit: Provides a tax-free death benefit to heirs, enhancing estate planning objectives.
Disadvantages:
Complex Structure: Requires careful design and ongoing management by experienced advisors to ensure optimal performance and tax efficiency, especially to avoid becoming a Modified Endowment Contract (MEC).
Fees and Costs: Policies have internal costs (mortality charges, administrative fees). Proper design is crucial to ensure these are justified by the tax benefits and features.
Long-Term Commitment: Best suited for long-term savings goals; early surrender can result in losses.
Underwriting: Requires the insured to be insurable.
I – Identify Indicators and Implications: When CVLI Shines for Business Owners
The ideal candidate for a CVLI "synthetic Roth" strategy is typically a highly successful business owner who:
- Has maximized contributions to qualified plans and Roth IRAs (if eligible).
- Faces income limitations that restrict direct Roth IRA contributions.
- Is in a high marginal income tax bracket and expects to be in a similar or higher bracket in retirement.
- Seeks additional avenues for tax-efficient accumulation and tax-free distributions in retirement.
- Values liquidity and access to capital for potential business opportunities or contingencies.
- Desires strong asset protection from creditors.
- Is comfortable with a long-term strategy and understands the internal costs.
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G – Guide Client Through Process: Making the Case
For business owners who take calculated risks with their enterprises, why take unnecessary risks with their personal retirement savings? This synthetic Roth, with proper structure and design, is often the best option for those who qualify, offering a robust blend of tax advantages, liquidity, and asset protection that traditional plans often cannot provide concurrently.
Here's how to frame the conversation:
"Mr./Ms. Business Owner, you've built a remarkable enterprise, and you're accustomed to strategic thinking. Instead of solely relying on the business for your retirement, let's explore how we can convert business income into personal savings tax-efficiently, take money off the table, and protect it with flexibility. This is crucial, especially given the statistics on business sales at retirement.
We've discussed the strengths of qualified plans for immediate tax deductions and tax-deferred growth, and the pure tax-free nature of Roth IRAs, despite their income and contribution limitations. However, for an individual in your position, we believe a properly designed cash value life insurance strategy can serve as a 'synthetic Roth' – allowing you to accumulate significant wealth, access it tax-free when needed (even before 59½), maintain liquidity for business opportunities, and shield these assets from potential creditors.
Imagine having a significant pool of personal capital that grows tax-deferred, that you can tap into tax-free for retirement income or even for strategic business investments, and that is generally protected from unforeseen events. This creates a powerful layer of financial independence, ensuring your retirement security isn't solely tied to the outcome of a business sale. It's about optimizing for maximum control, tax efficiency, and peace of mind in your personal financial future."
H – Holistic: Integrating with Overall Financial Planning
This strategy isn't a standalone solution but an integral part of a comprehensive financial plan. It complements qualified plans, diversifies asset locations, and enhances estate planning by providing a tax-free death benefit. Discussions should always include:
- Tax Implications: In-depth analysis of tax benefits and potential tax costs of any conversions or access strategies.
- Estate Planning: How the death benefit integrates with overall legacy goals.
- Risk Management: Understanding the costs and long-term commitment of the policy.
Business Succession Planning: Ensuring this supplemental plan aligns with the broader business exit strategy.
T – Transformational and Tax Efficiency: The Ultimate Outcome
Implementing a well-designed CVLI strategy can be truly transformational for a business owner's financial future. It shifts a portion of their wealth from being entirely dependent on a single, often uncertain, event (the business sale) to a highly flexible, tax-efficient, and protected personal asset. This provides the ultimate in tax efficiency, access, and security, creating the flexibility and freedom to retire on their own terms, irrespective of the business's eventual fate.
Disclaimer
This guide is intended for the exclusive use of financial advisors and is not for direct distribution to clients. As Apogee Capital Resource Group, a Capitas Financial team, we partner with advisors to provide advanced planning strategies. We do not provide tax, legal, or financial advice directly to clients. Clients should always rely on their own qualified financial, tax, and legal professionals to make informed decisions regarding their specific circumstances.
