There are three ways you can use 401(k) business funding to start or buy a business. You can cash out funds, borrow against them, or use a rollover for business startups (ROBS). The only option that doesn’t result in penalties, taxes, or interest charges is a ROBS, making it ideal for most situations.
A ROBS allows you to use savings in your 401(k) or IRA to fund your startup or to buy a business without any penalties or immediate tax obligations. If you have at least $50,000 in your retirement accounts, you can get a free ROBS consultation with the best ROBS provider, Guidant Financial.
3 Ways to Use Your 401(k) to Start a Business
| Funding Option | Best For |
|---|---|
| Rollover for Business Startups (ROBS) | Owners who have at least $50k in a qualifying retirement account and who want to start or buy a business without paying taxes or penalties. |
| Borrow Against a 401(k) (or IRA) | Business owners with less than $50k in a 401(k) or those who can repay their IRA in full within 60 days. |
| Cash Out a 401(k) or IRA | Owners who need more than $50k but don’t want to incorporate as a C-corp or pay a ROBS provider to help with a rollover. |
1. Use a Rollover for Business Startups (ROBS)
A Rollover for Business Startups (ROBS) lets you to invest retirement funds in a new business without paying taxes or early withdrawal penalties. A ROBS isn’t a loan or withdrawal, but is instead a way to tap into your retirement funds before retirement age. There are no monthly payments and no requirement to repay the money, even if your business fails.
A ROBS is a great way to use 401(k) business funding, particularly if you have more than $50,000 in a qualifying retirement account to invest. This is because if you have at least $50,000, you can work with an experienced ROBS provider to help you with the transaction. However, the cost can be expensive, and if you have less than $50,000 in your retirement account, you might be better served taking a loan against it.
You can use a ROBS for a business acquisition, working capital, or as a down payment for additional financing. If you want to use an IRA or 401(k) to buy a business or start a new company, a ROBS should be your first consideration, as it is the most cost-effective if you meet the specific criteria.
How to Set Up a ROBS
To set up a ROBS you must form a C corporation and then establish a 401(k) for that company. Next, you roll over funds from your personal 401(k) or IRA into the new company’s retirement plan. Using the funds you’ve just rolled over, the new 401(k) plan buys stock in the new C-corp. With that, your startup is funded!
Setting up a ROBS correctly can be difficult and time-consuming, which is why we recommend partnering with a ROBS provider. They can help you through the process of rolling over your retirement funds into your business and help you stay compliant with all legal and tax rules. Guidant, for example, offers a free, one-on-one consultation for any qualified individual interested in a ROBS.
ROBS Qualification Requirements
A ROBS isn’t a loan, so there are no loan qualifications. However, in order to use a ROBS, your business must meet certain criteria. You have to be set up as a C-Corp and have a Traditional 401(k) or IRA (as opposed to a Roth). You also need to be an employee of the new business.
In order to use a ROBS for IRA or 401(k) business funding, you must pass a few requirements, which include:
- Eligible Retirement Account: Both a Traditional 401(k) and IRA are eligible, but Roth IRAs can’t be used for a ROBS. Your retirement account must be a tax-deferred account and typically needs to be over $50,000 to be worth the setup fees.
- Business is a C-Corp: You must be willing to have your business registered as a C-Corporation. This is because the business is selling shares directly to a 401(k) account. Other legal entities, like an LLC, only allow you to sell shares of the business to real individuals.
- Be a Legitimate Employee of the New Business: If you use retirement funds through a ROBS, you must be an employee of the business for as long as the funds are invested. While there is no set number of hours that you need to work, a good rule-of-thumb is that you should work 1,000+ hours per year in the new business.
There are a number of administrative rules and regulations that you must follow if you use a ROBS, such as offering a retirement plan to eligible employees in your new business. To learn more about what administrative obligations you have with a ROBS, you can read our ultimate guide on ROBS.
Who a ROBS Is Right For
A ROBS isn’t always the best option for 401(k) business funding, but may be the best option if you have $50,000 or more in a 401(k) or Traditional IRA and will work full-time in the business. If you plan on retaining a full-time job while someone else runs your business, then you won’t qualify for a ROBS.
The typical things you need for a ROBS to be your best option include:
- Plan to work full-time in the business – If you plan on keeping outside employment or investing passively in the business, you won’t qualify for a ROBS.
- Have enough retirement assets to start or buy business – A ROBS will help you finance your business without having to take out a loan or accumulating business debt. A ROBS can also work well with additional financing to lower your overall debt.
- Identify a good provider – If you’re going use a ROBS, we recommend using a partner that’s experienced at setting up and administering ROBS. You can learn more about how the best providers stack up against each other by reading our article on the best ROBS providers.
“A ROBS can also be a great option for individuals who are a few years out from starting their business. You can save for your business in your retirement plan on a tax-deductible basis, instead of just throwing extra money into a savings account. You can access more money and save faster this way if your plan is to use a ROBS when the time comes to start your business.” — Joseph Hogan, Associate Financial Planner, RTD Financial
Guidant guarantees the use of outside counsel if the IRS audits your ROBS plan. They will help you through the whole process, give you expert advice on setting up your plan, and guide you through administering it afterward. You can contact them today for a free consultation.
2. Borrow Against a 401(k) or IRA to Start a Business
Those who have a 401(k) can borrow up to $50,000 or half of their vested plan, whichever is lower. Loan term is typically five years and interest payments are paid directly to the retirement account. Conversely, you can’t borrow from an IRA, although you can take money out for up to 60 days without penalty as long as you repay in full.
This means that you should only take money out of your IRA to start or fund a business if you know you can repay the capital in 60 days. If not, this might not be a wise choice, since you’re effectively cashing out your IRA and taking the hit on early withdrawal fees and taxes.
You are allowed to borrow money against your 401(k), and even though there are monthly interest payments (typically around 8%), the interest is repaid in the form of increased contributions. So, in reality, the interest payments increase the assets in your retirement account, making it a good option if you need less than $50,000 since it’ll be more inexpensive than working with a ROBS provider.
However, if you need more than $50,000, a ROBS becomes much more cost effective and might be your only choice available, since you can only borrow up to $50,000 against your 401(k). Let’s now take a look at the differences between borrowing against your 401(k) and momentarily cashing out of your IRA.
Borrowing Against Your 401(k)
According to a study by Aon Hewitt, around 26% of all 401(k) participants have a loan outstanding. This is a common practice that can help or hurt you, depending on how closely you follow the rules.
Employers make their own rules for how you can borrow against your account. Some employers limit loans to the contributions you’ve personally made into the plan, while others allow you to borrow against both your contributions and the matching contributions your employer has made. Each plan has its own rules that you must be aware of before attempting to borrow.
The IRS limits how much you can borrow from your 401(k) account to the lesser of either $50,000 or half of your vested balance in your plan. The loan term is generally for a maximum of five years, and the interest charged is comparable to a traditional business loan (~8%). These interest payments go directly back into your plan. The interest rate you pay is usually set by your plan administrator.
The IRS rules on 401(k) loans include:
- Limited to $50,000 or half your vested balance
- Loans limited to five-year terms
- Interest rates are set by the administrator (comparable to five-year business loans)
- Interest payments go back into your plan
Borrowing Against a Traditional IRA
Neither Traditional or Roth IRAs allow loans like a 401(k) plan may. However, they do allow for penalty-free distributions in some circumstances, like to pay for your education. However, there is currently no penalty-free distribution for starting or buying a small business.
How you can borrow money from an IRA is to take money for less than 60 days. If you fail to pay the money back within that 60-day window, it will count as a distribution from your account and you’ll be taxed as if you cashed it out (gross income tax with a 10% penalty). Each IRA account only allows you to do this one time within a one-year period.
Who a 401(k) or IRA Loan Is Right For
Borrow against your 401(k) or IRA if you’re staying with your employer for the foreseeable future, you won’t be a full-time employee of your startup, your business is earning passive income, or if you need less than $50,000 in funding. Borrowing can also be best if you expect access to additional funds within the next 60 days but you need the cash now.
To best protect yourself from penalties and taxes, you’ll want to repay anything you take from an IRA within 60 days. The same goes for a 401(k) if you separate from your employer. The minute you separate from your employer or move your 401(k) funds, the loan will come due within about 60 days.
3. Cash Out a 401(k) or IRA to Start a Business
Cashing out your 401(k) is the act of taking a distribution to start or invest in a business. However, if you’re under retirement age (59½), any non-qualifying distributions are assessed income tax and a 10% penalty. Qualifying distributions include things such as buying your first house or going back to school.
For this reason, cashing out your 401(k) or IRA to start a business should be your last option. Cashing out a 401(k) or IRA to start a business is only good if you’re over age 59½ or will have plenty of other retirement savings leftover. This is because your new business may not work out, but you may still need to pay taxes and penalties on the money you take from your retirement account. However, with a Roth 401(k) or IRA, you might be able to avoid some taxes.
Cash Out a Traditional 401(k) or IRA
Cashing out your 401(k) before age 59½ can create a lot of tax and penalty obligations. Contributions made to 401(k) and IRA accounts are made from pre-tax income. Taxes are charged not in the year you contribute funds, but in the year you withdraw funds.
This means when you cash out your 401(k), you’ll have to pay both federal and state taxes on the amount you withdraw as gross income for the year. This could also adjust the tax bracket you fall into. When you withdraw funds, your plan administrator will typically withhold 20% of the funds and send it directly to the IRS to potentially cover your federal taxes.
On top of the taxes, you’ll also have to pay a 10% penalty for withdrawing the funds before retirement age (59½). That’s a total of 30% in taxes and penalties right up front, and you could end up losing more in state and/or federal taxes. So if you’re cashing out $100,000 in funds, you’ll only get $70,000 immediately, and may have some additional tax liabilities to pay off.
There are a few exceptions to the 10% penalty that you may qualify for in either a 401(k) or IRA cash out, but none of them are related to starting or buying a business. These exceptions include:
- Qualified educational expenses
- Certain medical expenses
- Financial hardship as defined by the IRS
Cash Out a Roth IRA or 401(k)
Contributions to a Roth retirement account are not pre-tax contributions. Taxes are paid on the funds in the year the income is earned, and not in the year funds are withdrawn from your account.
Additionally, all withdrawals after you hit age 59½ are made without tax obligations as long as your plan is at least five years old. Cashing out your Roth IRA before that age will cost you a 10% penalty on all earnings within the plan, like the traditional IRA.
Contributions made to a Roth IRA account can potentially be withdrawn at any time without paying taxes or penalties. For this to work, the contributions have to pass the five-year test, meaning the contributions qualify if they’re in the plan for five+ years. However, the earnings within the plan can’t be taken out before age 59½ without paying taxes and penalties.
For example, if you put $20,000 into your IRA in 2017, then you’ll be able to withdraw that $20,000 tax and penalty-free at the end of 2021, but any money that $20,000 has made is not eligible. Using a Roth IRA to start a business may be ideal if you have a large number of contributions that have been in your retirement plan for at least five years.
Who Cashing Out a 401(k) or IRA Is Right For
Cashing out your 401(k) or IRA to start a business is typically a last resort once you’ve tried all other options. You’ll lose out on your funds being in a tax-advantaged retirement account and lose any potential earnings on those funds. It’s almost always the most expensive option.
However, there are two exceptions to this general rule, making a cash-out the right 401(k) business funding option. If you’re already at least 59½, or if you have a Roth IRA with a significant amount of contributions that have been in the plan for five+ years, then this may be your best option.
3 Ways to Fund Your Business with a 401(k) or IRA
Using Additional Funds to Start a Business
While the current average 401(k) balance has never been higher, according to Fidelity, it’s still just $92,500. This average amount may not be enough to start or buy the business you want. You may need additional financing to pay for your business.
You can generally combine your retirement savings with additional financing in two ways:
- As a Down Payment to Qualify for Other Financing: If you’re looking to get traditional financing, then you may be forced to put 10%-20% down at closing. You may be able to use your retirement funds as your down payment so that you can get approved for the full financing to purchase your business.
- As a Piece of the Capital Stack to Go with Other Financing: If you have a significant amount of money in your retirement account, but it’s not enough to start your business, then you may want to use it as just a piece of your full financing stack. This can lower your total debt and monthly payments, which could give your business a higher chance to succeed than if you financed the full amount through other sources.
Just because you have money in an IRA or 401(k) doesn’t mean that you can’t use those resources to help you start or buy a business. There are ways that you can use those funds to help fund your venture, but it’s important to the follow these rules to avoid paying undue taxes or penalties.
Common Types of Additional Financing
| Type of Financing | Best For |
|---|---|
| SBA Loan | Big business loans if you have good credit and can go through the application process |
| Home Equity Line of Credit | Low-interest financing if you have a lot of equity in your house |
| Personal Loan | Higher-interest, short-term loans |
| Credit Card | Month-to-month expenses or short-term financing on a 0% credit card |
| Seller Financing | Buyers who only need to loan up to 30-60% of the purchase price |
SBA Loan
SBA loans are popular for existing businesses in need of working capital. They’re also an option for many startups looking to finance the beginning or purchase of a business. SBA loans are difficult to qualify for, generally needing a 680+ credit score, a strong financial history, and possibly some collateral. For this reason, it’s more challenging for a startup to get an SBA loan.
SBA loans are also amongst the cheapest loans you can get with lower interest rates (6%-9%) and longer terms than other forms of financing. However, SBA lenders will typically require a down payment of 20%-30% of the total startup costs. Many people use their a 401(k), IRA, or ROBS for their down payment for an SBA loan. Learn more by reading our article on how to apply for an SBA loan.
Home Equity Line of Credit (HELOC)
A home equity line of credit uses the equity you have in your home to give you money for anything you need, including to fund your business. You can typically qualify if you have at least a 680 credit score and 20%-30% equity in your home, and you can borrow up to 80%-90% of total equity.
To learn more about whether a HELOC may be right for you, read our article on home equity lines of credit and whether you should use one.
Personal Loan
Personal loans come in many shapes and sizes. You can find personal loans at a traditional bank or at an online lender. Traditional banks will typically be cheaper, but they’ll be harder to qualify for and more time-consuming to get funded.
If you only need up to $35,000 of funding to start your business, then we recommend using a loan provider like Lending Club. You can also learn more about the ins and outs of using personal loans by reading our article on putting your personal money into your business.
Credit Card
Business credit cards are often overlooked as a startup financing source, but they’re also typically the easiest to get. You can apply and get approved within a few minutes, and in many cases start using your credit line immediately. Business credit cards are usually only for smaller financing needs (less than $20,000), and they carry APRs from 15%-30%.
To learn more about the best business credit cards, check out our article on the best small business credit cards. Further, read our article on how to use a credit card to fund your business for a specific breakdown on how to use one of the best business credit cards to build your company.
Seller Financing
Seller financing occurs when a motivated seller of a business is willing to loan a portion of the purchase price to the buyer. When this happens, the buyer will typically pay between 30%-60% of the asking price and the seller will receive the remaining 40%-70% as principal and interest payments over the life of the loan, typically five to seven years.
To learn more about seller financing, read our article on how seller financing works. Within the guide, you’ll see typical seller financing terms, the paperwork involved, as well as who it’s right for.
Frequently Asked Questions (FAQs)
What Is a ROBS?
A ROBS is a Rollover for Business Startup. It’s a tool that lets you use an IRA or 401(k) to fund a new business that you intend to work in. Using a ROBS allows you to use IRA or 401(k) business funding to set up your new business, but in order to use a ROBS, your business needs to meet certain criteria. For more information, check out our Ultimate Guide to ROBS.
Can I Borrow Money from a Self-Directed IRA?
Like other IRAs, you typically can’t borrow against a Self-Directed IRA. However, you are allowed to fund out for up to 60 days. So long as you replace the funds within a 60-day window, it’s only considered a rollover – not a taxable distribution. If you want to use your IRA to invest in real estate, there are some providers that can help you finance properties if you meet certain criteria.
Can a Self-Directed IRA Invest in an LLC?
Some providers of Self-Directed IRAs allow you to have checkbook control, where you can invest in almost anything just by writing a check. This includes closely-held companies like LLCs. However, you can’t typically invest IRAs in businesses like LLCs using traditional providers.
Can You Take a Loan from an IRA?
According to the IRS, you can’t technically borrow from or against your IRA. However, the IRS allows up to 60 days to complete IRA rollovers – so if you take money from your IRA and repay it within 60 days, it’s considered a rollover instead of a distribution. If you don’t repay the funds within 60 days, it will be considered a taxable distribution. If you aren’t yet 59½ or meet one of the IRS exceptions, you may also need to pay a 10% penalty for early distributions.
Can an IRA be Used as Collateral for a Loan?
An IRA cannot generally be used as collateral for a loan. There are exceptions, however, such as when you use your IRA to invest in things like real estate. Certain providers will allow you to use funds in an IRA for a down payment if you meet certain criteria. If you’re investing in real estate, for example, the property will need to be held in the name of your IRA. Your IRA will need to show adequate creditworthiness as a standalone borrower because you can’t personally guarantee these loans.
Bottom Line
Your 401(k) or IRA funds can be used to start or buy your business, but the way you should do it depends on your own situation. Cashing out your 401(k) or IRA could work for your startup funding if you’re currently in the lowest tax bracket. Borrowing against your retirement account could also work if you know you’ll be able to pay back the funds within 60 days.
Our recommended solution in using your retirement funds to start or buy a business is a rollover for business startups (ROBS). With a ROBS, you can fund your new business without paying taxes or penalties. To do it correctly, you need to use an experienced ROBS provider who will tailor the ROBS to you. Our recommended provider is Guidant, who will give you a free consultation.
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