How to protect your personal finances when launching a business

There were nearly 5.4 million new business apps in the United States last year, according to an analysis of census data by the Economic Innovation Group, the largest number of startups launched in a single year on record. And that adds up to a record year in 2020.
But not every startup is the next Apple or Netflix. While there is the potential for great long-term rewards for entrepreneurship, there are also many financial hurdles to overcome along the way. For starters, about a third of small businesses fail within the first two years, according to the Small Business Administration.

“In the corporate world, many seek and few are chosen,” said Clark Kendall, president and CEO of wealth management firm Kendall Capital in Rockville, Maryland. “You have to go in with your eyes wide open to the risks.”

When it comes to your personal finances, the risks of starting a business can include losing some, if not all, of your savings, your income, and possibly your assets, if you’re not careful. There is also opportunity risk.

“You could have worked for someone else and received a steady paycheck instead of risking starting a new business with unknown future earnings and income,” Kendall said.

That said, for companies that are successful, there is also a lot of upside potential. But no matter how focused they are on business, it’s important for small business owners to think about their personal finances, too. If you’re ready to join the growing ranks of the self-employed, take the following steps to protect your finances:

1. Prepare for a financial sacrifice…at first

Most companies don’t make any money for the first few months (or longer). If this is your full-time focus, that means you probably won’t be making any money for a while. If possible, start building your personal savings before you launch the business so you have the resources to cover your bills and living expenses during that time.

Chad Parks, founder and CEO of Ubiquity Retirement + Savings, recommends setting aside at least six to nine months of expenses if you’re starting a business and don’t have any other income to fall back on. Consider that money untouchable, and only for use within the business.

“When you start a business, there’s always a sacrifice up front. That’s on the financial side, as well as the time to get the momentum going,” said Nick Foulks, director of communications strategy and customer engagement at Great Waters Financial.

How much do I need for emergency savings?

Once the business begins to generate income, you’ll also want to start setting aside cash reserves, up to a year’s worth of business expenses, so you can separate your own financial responsibilities from those of the business.

“Many entrepreneurs make the mistake of treating their business like a bank account and just taking money out when they need it,” said Robert Gilliland, managing director and senior wealth advisor at Concenture Wealth Management.

2. Get on payroll

As soon as you start getting a paycheck from the business, you’ll also want to start putting money into a retirement account. Even if you can’t contribute much, the sooner you can get into the habit of saving for retirement, the better.

“We’re creatures of habit, so you have to get used to paying yourself with a paycheck,” said Marcus Blanchard, Certified Financial Planner and founder of Focal Point Financial Planning. “There are many retirement savings options for entrepreneurs.”

The savings vehicle you use will depend on your financial picture and the type of business you run, but here are three common accounts:

A traditional Individual Retirement Account (IRA) or a Roth IRA

If you’re saving $500 a month or less, an IRA may be the best option because you can only contribute $6,000 a year if you’re under 50 ($7,000 if you’re older). You can set up an IRA at any brokerage account and They come in two varieties: Traditional IRA contributions are pre-tax and grow tax-free, and you don’t pay taxes until you make withdrawals in retirement. With a Roth IRA, on the other hand, contributions are made after taxes, but you never have to pay taxes on growth or qualified withdrawals. In general, a traditional IRA makes sense for those who believe they will be in a lower tax bracket when they retire, since withdrawals are taxed at your current tax rate. Meanwhile, those who think their tax bracket will increase should stick with a Roth.

I am retired, how long will my savings last?

A single 401(k)

You can contribute up to $20,500 to a Solo 401(k), and many brokerages also allow you to have a Roth 401(k) option within the account. In addition, you can make a profit sharing contribution to the account as a business owner. That amount can be up to $40,500 (or 25% of eligible earnings), for a potential total of up to $61,000.

TO SEP IRA

When income increases, a simplified employee pension plan (SEP) can help offset the years you may have missed saving for retirement while building your business. You can contribute up to 25% of your income or $61,000 per year, whichever is less. (The deadline to open a SEP is tax day, so you may still have time to open an account and make contributions that count toward your 2021 taxes.)

3. Remember that your business is not your savings

There is a tendency among many entrepreneurs to think of their business as their main retirement asset. They often plan to sell the business when they retire or turn it into a source of income that allows them to live comfortably while someone else runs it. While either scenario could occur, financial planners advise entrepreneurs to make sure they take other steps to set aside cash for retirement.

“You never know what could happen to your business,” Parks said. “There could be a war, there could be a global pandemic. That’s why you need to diversify.”

Correction: An earlier version of this story erroneously stated the location of Kendall Capital. The firm is located in Rockville, Maryland.

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