There are a few ways to use a 401(k) to fund a business, each with pros and cons. Find out if using this method of financing is right for you.
Why You Might Use Your 401(k) To Start a Business
Advantages
A 401(k) can be a great source of starter funds because:
Its owner has control over the capital source and where the money is going. The money is available quickly. The entrepreneur is not incurring debt from a third-party institution. Certain types of business withdrawals can be made without paying penalties or income taxes. All interest is paid back to the owner. It does not require a credit check, and your credit score will not be affected. Most people qualify. It’s good for short-term investments in which a quick return on investment (ROI) is expected, such as buying a franchise or equipment.
Risks
A 401(k) can be a risky source of business starter money because:
It is a drain on personal retirement savings and will require careful planning to recoup the funds.You are risking your retirement savings if the business fails.Some loan terms are dependent on employment status.Not all plans allow business financing, and they vary on how the loans should be repaid.
Options When Using 401(k) Loans To Start a Business
To start a business using a 401(k), an owner should consider the different types of withdrawals, including a 401(k) business loan, a Rollover for Business Startups (ROBS), and a 401(k) distribution.
401(k) Business Loans
If a plan permits, a borrower can apply to take out a 401(k) business loan from their retirement account. This loan is for people who plan to stay employed in their current position and want to take out less than $50,000.
How It Works
Borrowers sign a loan agreement with the terms of interest, fees, and other specifications. Typically, a 401(k) loan term is five years—it can be shorter, but not longer. Most loans are repaid through payroll deductions. Borrowers are expected to pay market interest rates; however, this interest is later paid back to the owner. Penalties and income taxes are not incurred when taking out a 401(k) loan, making it a cheaper option than a typical withdrawal. However, interest repayments are double taxed: They are paid with after-tax dollars, then taxed again when the borrower withdraws them for retirement.
Eligibility Requirements
An employer’s 401(k) plan may or may not offer loans. If it does, most people qualify since the money is coming directly out of the borrower’s funds. Some plans require borrowers to get consent from their spouses or domestic partners to take out a loan. This is because a spouse may be entitled to a portion of the 401(k) in case of a divorce, and their share may be affected by the loan.
How Much Can You Borrow?
If a plan permits a 401(k) loan, the IRS lets you borrow 50% of your vested total account balance. This amount is capped completely at $50,000. If you have $40,000 in your account, for example, you can borrow a maximum of $20,000. But if you have $1 million in your account, you still can’t borrow more than $50,000.
Pros and Cons of 401(k) Business Loans
Consider the following advantages and risks when deciding if a 401(k) business loan is right for you.
What Happens If You Can’t Pay Back a 401(k) Business Loan?
If a borrower defaults on their loan, it is treated as a withdrawal subject to back income taxes. Borrowers younger than 59 ½ will also have to pay a 10% penalty fee. This could seriously deplete a business owner’s retirement account.
ROBS To Start a Small Business
A ROBS plan is a withdrawal from a 401(k) that is transferred into a business’s new retirement account. This withdrawal should be more than $50,000, and it is not subject to penalties or income taxes. Many entrepreneurs consider this option as an alternative to going into debt through traditional business loans. A ROBS requires more convoluted steps than a 401(k) loan.
How It Works
A business owner must use the cash infusion in their new business retirement account to buy stock in their company. This builds up starting capital to fund the business without the hassle of loans, debt, or tax penalties. However, that business owner must also go through a rigorous eligibility process.
Eligibility Requirements
To consider starting a ROBS plan, a business owner must meet the following qualifications:
Employer plans must allow the rollover of funds from the 401(k). Many plans do not allow this while the borrower is still employed by that company, but funds from previous employers may qualify.A ROBS applicant usually must have $50,000 or more in a pre-tax, rollable retirement account to qualify.
To apply for a ROBS, a business owner must:
How Much Can You Invest?
Generally, ROBS plans require that business owners should invest no less than $50,000.
Pros and Cons of ROBS
ROBS should be carefully analyzed from all angles. Here are some important considerations.
Distribution From Your Retirement Account
Under certain circumstances, a business owner may withdraw funds directly from their 401(k) for distribution purposes toward their company. They won’t have to pay the money back, but they must meet strict qualifications for the funds to be made available, and the funds are taxed.
How It Works
If eligible for distribution, an employee may opt for their 401(k) plan to distribute benefits in one of three ways. It could be paid out as a lump-sum payment, in multiple payments over a set period of time (for example, five or 10 years), or in an annuity with monthly payments over a lifetime. When you make a distribution of $10 or more, the retirement plan administrator will send you Form 1099-R, which outlines the withdrawal amount in addition to the 20% taxes being withheld. Borrowers may also face a 10% taxation for withdrawal if they are younger than 59 ½ years old.
Eligibility Requirements
Plans permit distribution when an employee:
Reaches age 59 ½Loses employment (by death, disability, retirement, or other cause)Has their plan terminated, and there is no distribution plan defined by the employerSuffers a hardship, putting them in immediate and heavy financial need
How Much Can You Borrow?
Your distribution amount depends on the agreement between you and your employer plan. Usually, if the balance exceeds $5,000, an account owner must give consent before the plan administrator makes a distribution. The plan may also require the consent of your spouse or domestic partner.
Pros and Cons of Distribution From Your Retirement Account
Before taking a 401(k) distribution, weigh the following pros and cons.
