People have many reasons behind why they want to start their own business — following passions, creating a better work/life balance, choosing the people they want to work with (or for), just to name a few. The motivation I hear most often, though, is that they want the control over their own destiny and the income that owning a business provides (whether that business is a “side hustle” or their full-time source of income).
I know what you’re thinking… a business that you’re passionate about, with great work/life balance, and the most perfect employees and customers ever sounds a bit too good to be true, doesn’t it?! And maybe you’d be right. Business ownership is certainly not all glamor all the time. It can be as risky as it is rewarding, and many do fail, so it isn’t a good fit for everyone.
On the other hand, being a business owner does give you a good deal more control than being someone else’s employee. You have the ability to shape your business in a way that best benefits you. From a personal wealth building perspective, that can be a powerful thing.
Today, we’ll dive deeper into some financial planning tips for small business owners that will help in growing personal wealth.
Income vs. Wealth
In using a business as part of your personal financial plan, it’s critical to differentiate between business income, personal income, and personal wealth.
Business Income
Business income is income that’s generated from business activities. It could be from product sales or services rendered.
You have some control over this number through business activities — for instance, by marketing your product or actually performing and billing on the services you provide. At the end of the day, though, your product/service will need to have enough interest from customers that are willing to pay your company for it.
Personal Income
Once you have customers paying the business and there’s enough business income to be able to pay yourself, you can then decide how much personal income you want to take from the business income. To some extent, you’ll have more control over this number than the business income number, but you’ll never be able to pay yourself more than your business’ income.
As a side note: using a small business to generate personal income is one of our recommended ways of growing lifetime earning potential, also known as human capital. Human capital is an important area of personal finance for younger clients to focus on, as small improvements early in one’s life could have exponential benefits near or in retirement.
Personal Wealth, aka Net Worth
At LifeSighted, we track personal wealth using a net worth statement. This is the total value of all personal assets (i.e., your house, business, investment or retirement accounts, bank or savings accounts, etc.) minus the value of any personal debt or liabilities, like a mortgage or credit card balances.
Now that you know what the differences are between business income, personal income, and personal wealth, I’m going to assume that, as a small business owner, your goal will be to utilize the business’ income to generate growth in your personal net worth.
1) Treat Your Business Like An Asset
A small business is an asset and an investment and should be treated as such. As the business owner, you own “stock” in the business (probably even 100% of it). Unlike owning individual shares of other stocks, like Amazon or Tesla, though, you actually have control over the value of your own business. (Individual stock ownership is not an investment strategy we typically recommend, if you can avoid it.)
If you’ve never thought about your business like an asset before, that’s OK. Now’s as good of a time as any to begin.
Track The Value & Include It In Your Personal Net Worth
To start tracking, you’ll need a beginning value. Estimate the value of your business such as it is. Business valuation is highly dependent on the industry that the business is in, but is often expressed as a multiple of annual revenue. Unless you’re looking to sell the business immediately or otherwise need a specific number, paying for an official business valuation is not necessary. An estimate will do.
Once you have an idea of what the business is worth now, keep an eye on the value of your business over time. I recommend taking annual snapshots and tracking it so you can see the progress.
2) Diversification is Key
Diversification is important in many areas of your life, but particularly when it comes to investments. And, as mentioned above, a small business is an investment for the business’ owner.
When you are receiving personal income from a small business that you also own (as most owners do), you’re opening yourself up to more risk than is necessary. If something were to happen to the business, you’d take a hit to both your personal net worth (via the value of the business) and your income (via the portion of your income that’s coming from the business). To protect yourself from this risk, it’s always a good idea to move money from the business to your personal accounts by paying yourself an income or otherwise, as you’re legally able.
Once the money is in your personal accounts, invest it according to your personal financial plan, focusing on what you can control within your portfolio – risk, costs, diversification, and regular rebalancing.
It’s important to note that diversification is a risk mitigation strategy. You might be taking some growth off of the table by not reinvesting these assets in a quickly growing business, but you’re also protecting yourself and your wealth from the volatility of the economy, your business, or the industry it’s in.
3) Take Advantage of Retirement Accounts
Retirement accounts offer phenomenal tax advantages and allow you to increase your personal wealth by taking advantage of savings limits from both your personal income (via elective deferrals) and the business income (in the form of profit-sharing).
There are a number of options when it comes to the types of retirement accounts or even how those retirement accounts are setup. This will leave you with a good deal of flexibility, but it is possible to screw up.
In general, you’ll want to go with the choices that allow you to put the most money away for retirement while keeping it from being taxed. The specific retirement account choice and options will be dependent on the make-up of your business (business structure, business income, the number and type of employees, other income for you or your spouse, etc.).
Most often, I see small business owners choosing Solo 401(k) (with the ability to handle both Traditional and Roth contributions) or SEP IRA accounts for their businesses. However, due to the number of choices and variability in businesses and the owner’s goals, I have to recommend that you talk to a professional to determine the retirement account that best fits you and your business’ specific situation.
If Your Small Business is a “Side Hustle” or Your Spouse is an Employee – Coordinating Multiple Retirement Accounts
Under certain circumstances, like when your business is a “side hustle” or your spouse is an employee of your business but also has access to another 401(k) through their full-time job, the retirement account of choice for your business might be counterintuitive. In situations like this, you will want to look at the aggregated effect of multiple retirement account types, and their maximum contribution limits, to see which combination offers you the ability to save the most.
For example, let’s say you have an LLC, which is your “side hustle.” You also have a full-time job that offers a 401(k), with an employer match to boot. If you didn’t have the full-time job, you would’ve opted for a Solo 401(k). But because your full-time job has an employer match and you can only defer $19,500 max this year to any/all of your 401(k) accounts, it would likely be better to maximize your elective deferrals to your job’s 401(k) to take advantage of the “free money” from the employer match. Then, for your LLC, you get to maximize contributions to a SEP IRA instead of going with a Solo 401(k).
4) Reduce Taxes To Grow Wealth
Deducting as many business expenses as you’re legally able to helps reduce your income taxes. Depending on the type of expense, it could even directly contribute to growing your wealth as well. Examples of the latter include the mortgage interest deduction for a home office and retirement account administration fees.
A lot of deductible business expenses are likely to be present in your life whether you’re running your own business or not, so you might as well pay for a portion of them with tax-free money.
- You probably pay for a cell phone. You’ll probably be using it a lot for business.
- You might have a car, depending on where you live. You might be using it a lot for business.
- You should definitely have health insurance. Guess what. You get to deduct the unreimbursed premiums as a business expense.
Many business owners plan purchases with the understanding that they’ll use the item for business, but that they will also probably enjoy some incidental personal use as well.
5) Create an Estate/Succession Plan to Pass The Value of Your Business On To Loved Ones
An estate plan allows you to protect your personal wealth and pass assets to future generations in the way that you specify. For individuals, this can be relatively simple, or it might be complex, depending on where you live and what your estate looks like.
Without having a similar plan for what happens to your business should something happen to you, you run the risk of losing the full value of this asset that you’re building.
There are a number of different strategies, like insurance, buy/sell agreements, or other types of succession plans, that you could employ to ensure your loved ones get the value of the business as a part of your estate. At the end of the day, though, the specific business estate plan strategy is going to be very personal to your situation. As such, it should be discussed with your financial team and an attorney.