Should I Finance My Business With My 401(k)?
Since the “Great Recession” of 2008, financing a business has become more challenging than ever, especially if you don’t have a track record as an entrepreneur. For entrepreneurs who are desperate for startup cash, taking a 401(k) loan from your retirement savings may start to sound like a smart idea.
There are two ways you can use a 401(k) to finance your business: 1) by taking out a 401(k) loan and 2) by rolling over your balance into a new 401(k) plan, called a ROBS. Here’s a look at each option.
If your 401(k) plan allows loans, the IRS permits you to borrow up to half of your vested balance, or $50,000, whichever is less. Be sure to check with your plan administrator; some plans restrict what borrowed funds can be used for.
- 401(k) loans typically have lower interest rates than many other types of business loans.
- You may feel better about paying yourself back vs. being indebted to a third party.
- The interest rate of a 401(k) loan isn’t the only factor to consider. You’ll also need to pay:
- Loan fees such as origination and administration costs.
- A 10 percent penalty for withdrawing the retirement funds early (if you’re under age 59 ½).
- Income tax on the entire balance of the loan if you fail to pay the loan back within the loan term (generally five years).
To avoid the 10 percent early withdrawal penalty, some startup entrepreneurs use a different form of 401(k) financing known as a Rollover-as-Business Startup (ROBS). Here’s how it works:
You create a C corporation that sets up its own 401(k) plan. Then, you roll over the funds from your existing 401(k) into the new company’s 401(k). (Since it’s a rollover, not a distribution, you pay no taxes or penalties.)
Your new corporation issues stock, the new 401(k) invests in the corporation by buying its stock, and the money used to buy the stock becomes a source of capital for the new corporation. (One catch: You can’t pay owners’ salaries from these funds.)
- You avoid paying taxes and penalties on the money you use to start your business.
- Do ROBS sound too good to be true? The IRS thinks so too, and keeps a close eye on ROBS, which it has called “questionable.” You’ll need to enlist a company experienced in setting up ROBS to get you through the process, and to ensure continued compliance going forward so you don’t get hit with an audit or penalties. These costs quickly add up.
- You now have the headaches of administering a 401(k) plan, including educating employees about the plan and allowing them to participate.
The big “con” of either 401(k) financing option is that if your business fails, you could lose both your company and part—or all—of your nest egg. Is that really worth the risk? Personally, we recommend trying every other tactic under the sun before you even consider this one.
- Guidant Financial and Benetrends are two financing firms that help entrepreneurs set up ROBS.
- Bankrate has a calculator you can use to figure out the true cost of borrowing from your 401(k) plan.
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