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Case Study: Franchise Owner Looks for to Retire Early
Like many people in their 30s, Compton resident Vincent Shepherd is trying to juggle his financial goals, including paying off debt, buying a home and investing for retirement.
But Shepherd's situation as a small-business owner and a landlord gives him some special financial-planning opportunities not available to others. In particular, both his business and his rental property can be used as assets for retirement, said Greggory J Hutchins, a certified public accountant who reviewed Shepherd's finances.
Shepherd still may not be able to quit work at 55, as he had hoped, but those advantages could give him an earlier retirement than had he continued his previous career of teaching.
Shepherd, 36, purchased a Togo's sandwich franchise in Monterey Park last year, leaving behind a seven-year career as an elementary school instructor.
"I sort of stumbled into teaching," said Shepherd, who had taken a substitute-teaching job to pay the bills while he pursued a real estate career. "I'd always wanted to go into business for myself."
Teaching paid better than real estate, which was going through a slump at the time, and Shepherd let his agent's license lapse. But as the economy improved, Shepherd revived his dream of going into business for himself. With $43,000 borrowed from family, credit cards and his retirement plan, Shepherd was able to get a bank loan for the additional $125,000 to buy the business.
Shepherd said the business was profitable from the start. In the first half of 2000, his store grossed more than $336,000, which allowed Shepherd to boost his monthly salary to $6,000. He has 24 part-time employees, mostly college students. Although he started the business as a sole proprietorship, in July he switched its status to an S corporation.
Hutchins approved of that move, saying the S corporation structure protects Shepherd from being held personally liable should the business be sued. In fact, Hutchins said Shepherd's business skills bode well for his future--which makes it all the more important to start planning for growth now.
"He has the ability to do bigger and better things," Hutchins said. "In a few years he could be pulling in a couple hundred thousand [in salary], which means he'll be playing with a much bigger playbook."
For the most part, Shepherd has kept his expenses relatively low. He lives with his mother, paying just $200 a month for rent. He invests $150 a month in a mutual fund and gives $375 in charitable contributions. He also pays between $500 and $1,000 a month toward a personal $10,000 credit-card debt that he recently transferred to a card with a 5.9% interest rate, and hopes to be free of the debt within a year.
His only other large expense--$1,074 for a mortgage payment, taxes and insurance on a home he owns--is covered by the $1,000 a month he receives in rent along with the tax break he gets for depreciating the property.
Now that his business is doing well, however, Shepherd is looking for a home in the $250,000 range. He wants to get a 95% mortgage and tap his savings for the $12,500 down payment.
Hutchins understands Shepherd's eagerness to have his own place. But buying a home would increase expenses by at least $2,000 a month, and Hutchins feels Shepherd's first priority should be setting up a retirement plan, preferably through his company.
As a teacher for the Compton Unified School District, Shepherd was covered by the California State Teachers Retirement System, which could have paid him a pension equal to 70% or more of his salary had he continued to teach until retirement age. He also contributed $500 a month to a tax-deferred annuity offered to district schoolteachers. The annuity has performed poorly, returning just 5%, although it did provide a cheap source of funds to start Shepherd's business, Hutchins said.
Now that he's self-employed, Shepherd must bear most of the burden for saving for retirement. Fortunately, he has several options, Hutchins said.
Shepherd could set up a defined-contribution plan that would enable him to put aside up to $30,000 a year for retirement.
He could also institute a full-fledged pension plan. These plans, also known as defined-benefit plans, could allow him to contribute even more to a retirement fund, because the contributions to the plan would be based on actuarial assumptions about how much money he would need in order to pay himself a set benefit in retirement. Such plans can even be skewed so that only Shepherd, and not his employees, are eligible.
Unfortunately, defined-benefit plans can be difficult and expensive to set up, especially for a small business. Failing to do it correctly could result in the Internal Revenue Service disqualifying the plan, which would mean any contributions could be subjected to taxes and penalties, Hutchins said.
A better choice right now, given Shepherd's income and the size of the business, would be a relatively new and easy-to-administer plan appropriately called a SIMPLE, for savings incentive match plan for employees, Hutchins said. This would allow Shepherd to contribute up to $6,000 of his salary annually to a retirement account. The company could then match his contributions, up to 3% of his salary. Shepherd could set the account up, with the help of a pension administrator or knowledgeable CPA, at most brokerages, allowing him access to thousands of individual stocks, bonds and mutual funds.
A potential drawback of a SIMPLE, in some employers' eyes, is that any employee who earns more than $5,000 a year must be allowed to participate and earn the matching funds. But it is unlikely that many of Shepherd's college-age workers will want to contribute--and even if they did, the costs would be low.
"These are college and high school students. They're not thinking about retirement," Hutchins said.
As the corporation grows and profit increases, Shepherd could later add a more sophisticated defined-contribution plan that would allow him to set aside more money, said Raymond W. Liden, principal of Westlake Village pension administration firm Liden, Morton, Nestle & Soled, Inc. One option that would be more complicated, and thus expensive, to administer would allow him to contribute 20% or more into his account, Liden said.
Shepherd said he definitely wants to grow his business to include other franchises. Hutchins also recommended Shepherd expand current revenue by marketing the catering side of the business, a sideline that, until now, has generated little income.
Hutchins recommended that he target the local business community by advertising and networking.
"One simple and inexpensive way to do this would be to join the local Chamber of Commerce and Rotary Club," Hutchins said. "By actively participating in these civic organizations, Vincent should be able to establish a positive reputation in the community, expand his network and increase his catering business."
Shepherd also has several options for his two-bedroom, one-bath home, which he bought in 1997 as a rental investment property.
One possibility is that Shepherd could move in to the rental, converting it into his primary residence. After two years, he could sell it and take advantage of the capital gains exclusion that allows a single person to avoid paying taxes on up to $250,000 of home sale profit (or $500,000 for a married couple). Shepherd would have to pay a tax of 25% on the depreciation he took while the home was a rental. The proceeds from the sale could then be used as part of a down payment on a larger home, Hutchins said. Shepherd would save about $6,500 in taxes even if the home does not appreciate in the next two years, Hutchins said.
If he decides not to make the rental his home, Shepherd could exchange it for another rental property of equal or greater value in a tax-free transaction known as a 1031 exchange, Hutchins said. Shepherd would need the help of a third-party accommodator, such as a bank trust department, to hold the proceeds from the sale and would need to acquire the replacement property within 180 days.
That option appeals to Shepherd, who said that his experiences as a landlord have been positive and that he has been thinking about buying an apartment building.
But Shepherd should remember that his ability to write off rental losses will become restricted as his income climbs, Hutchins said. Right now, Shepherd's income is low enough that he is allowed to deduct up to $25,000 in rental losses each year. The ability to write off losses on a rental for people who manage their rentals begins to phase out when income for single or joint filers reaches $100,000 and it disappears at $150,000.
Rental property could provide Shepherd either income in retirement or be an asset that can be sold to fund his retirement, Hutchins said. Likewise, his business would probably be sold for retirement income. How much those assets would be worth is hard to predict, which is why a separate retirement account invested in stocks, bonds and cash is important.
If Shepherd contributes $500 a month to the SIMPLE and the assets in that plan and in his current IRA grow at 8% a year, Shepherd would have a $403,000 nest egg at age 55.
"However, this may not be enough for Vincent to retire on, given that he would still have a life expectancy of approximately 26 years," Hutchins said.
Assuming his fund earned 7% in retirement, Shepherd would be able to draw only $2,800 a month, or less than half his current salary if inflation is not considered. If inflation averages 3% a year, that payment would be worth about a quarter of his current salary in 19 years, and the value would continue to shrink as he aged.
Were he to continue working until age 65, the retirement pot could grow to nearly $1 million--and his retirement period would shrink to 18 years, using current life-expectancy tables. That would give him an average monthly payment of $8,000. In the first year of his retirement, that payment would equal about 57% of his current salary if inflation averages 3%.
Presumably, Shepherd's other assets will help beef up his retirement income, or he could consider boosting his savings with contributions to a Roth IRA and investing on his own outside a retirement account, Hutchins said.
Shepherd said he would probably contribute more to his retirement as his business expands and gauge the growth in value of his assets before making the decision to retire. But he would still like to do so well before age 65, he said.
"I want to see the world and travel, and the earlier I can do it, the better," Shepherd said. "I want to do everything I can to make that happen."