Many entrepreneurs assume their business will fund a substantial portion of their retirement. While equity in a business can be an important source of retirement income, it’s important to diversify your income sources and hold assets outside your business, such as a registered retirement savings plan.
Most people share the same long-term goal and that’s to retire comfortably. They also share two short-term goals: to purchase or pay off a house and to fund their children’s education.
But small business owners generally have a third short-term goal and that’s to grow their business. “Unfortunately, that need competes very strongly with their other short-term goals,” says Audrey McFarlane, a financial adviser with Edward Jones in Victoria, B.C.
Though many entrepreneurs don’t want to consider another asset class for at least the first 10 years of their business's life, saving for retirement is important and not just because they face a retirement without a defined pension plan. Investing at least a portion of their salary in an RRSP offers the many benefits of diversification.
“You should never have all your eggs in one basket and that includes small business owners,” McFarlane says. A retirement plan based solely on the sale of a business is risky. “It assumes the business will be successful and profitable and that they can sell it for a value that will fund their retirement. What if you’re wrong?”
Building your RRSP — even through modest contributions — while also building your business also offers you a nest egg. Though an RRSP isn’t intended to serve as an emergency fund, it can play that role in the “worst-case scenario.” Remember, an RRSP isn’t designed to reduce taxes but rather to defer them, ideally until retirement when your income — and rate at which you’re taxed — drops.
“If you put the money in today and take it during an emergency, generally the emergency is that you don’t have any income so you’re obviously in a lower tax bracket...so it still works the way it’s supposed to,” McFarlane says.
An RRSP also offers the possibility of creditor protection. “In many cases, it also gives you estate value and estate value people can get their hands on fairly quickly as opposed to winding up a business, particularly if there are partners,” she says.
Even if you’re starting a business when young, investing in your RRSP right away makes financial sense because you’ll realize the benefits of compounding. Still not convinced? McFarlane points to the Rule of 72, which is a way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, you can get a rough estimate of how many years it will take for your initial investment to duplicate itself.
Of course, a business owner might argue their business is growing at 10%, 20% or even 30% a year so it doesn’t make sense to invest in an RRSP with the expectation of earning just 6%. But don’t overlook the benefits an RRSP offers, along with an estate value that will help make up for the initially lower return by the time they use it, McFarlane says.
One in 10 Canadians own a business
Women lead more than a third of the country’s small- and medium-sized businesses
Canada is home to 1.1 million businesses and 98.2% of those have fewer than 100 employees
Source: Business Development Bank of Canada