How to protect your personal finances when you launch a business

By Beth Braverman

Millions of Americans left or lost their jobs during the pandemic and many have decided that they don’t want to go back to work …. at least not for someone else.

There were nearly 5.4 million new business applications in the United States last year, according to an analysis of Census data by the Economic Innovation Group, the highest number of startups launched in a single year that has been recorded. And that came on top of a record year in 2020.

But not every startup is the next Apple or Netflix. While there’s potential for great long-term benefits to entrepreneurship, there are also a lot of financial hurdles to clear 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 world of entrepreneurship, 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’s 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 revenue and income,” Kendall said.

That said, for the businesses that succeed, there’s also plenty of potential upside. But no matter how focused they are on the business, it’s important for small business owners to think about their personal finances as well. 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 businesses don’t make any money at all for the first few months (or longer). If this is your full-time focus, that means you likely won’t be making any money for a while. If possible, start ramping up your personal savings before you launch the business, so that you will have resources to cover your bills and living expenses during that period.

Chad Parks, founder and CEO of Ubiquity Retirement + Savings, recommends having at least six to nine months’ of expenses set aside 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’re starting a business, there’s always a sacrifice up front. That’s on the financial side, as well as in time to get the momentum going,” said Nick Foulks, director of communications strategy and client engagement at Great Waters Financial.

Once the business starts generating revenue, you’ll want to start setting aside cash reserves as well — up to a year’s worth of business expenses — so that you can separate your own financial responsibilities from that of the business.

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

2. Put yourself on the payroll

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

“We are creatures of habit, so you want to get used to paying yourself with a paycheck,” said Marcus Blanchard, a certified financial planner and founder of Focal Point Financial Planning. “There are a lot of options for retirement savings for entrepreneurs.”

The savings vehicle you use will depend on your financial picture and the type of business you have, but here’s a look at three common accounts:

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

If you are setting aside $500 per 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 go in 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 go in after-tax, but you don’t ever have to pay tax on the growth or qualifying withdrawals. In general, a traditional IRA makes sense for those who believe they’ll be in a lower tax bracket when they retire, since withdrawals are taxed at your current income tax rate. Meanwhile, those who think their tax bracket will go up should stick with a Roth.

A Solo 401(k)

You can contribute up to $20,500 to a Solo 401(k) account, 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 profits), for a potential total of up to $61,000.

A SEP IRA

When revenue goes up, a Simplified Employee Pension plan (SEP) can help make up for years you may have skipped out on retirement savings while you were building the business. You can contribute up to 25% of your income, or $61,000 per year, whichever is less. (The deadline for opening 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 nest egg

There’s a tendency among many entrepreneurs to think of their business as their primary retirement asset. Often they plan to either sell the business at retirement or build it into a cash cow that allows them to live comfortably while someone else runs it. While either scenario could happen, financial planners advise entrepreneurs to make sure they’re taking other steps to set cash aside 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 misstated the location of Kendall Capital. The firm is located in Rockville, Maryland.

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