There are three ways you can use 401(k) business financing 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 does not result in penalties, taxes, or interest charges is a ROBS, making it ideal for most situations.
If you are considering using retirement funds to start a business, a ROBS allows you to use savings in your 401(k) or IRA with no 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.
3 Ways of Using a 401(k) to Start a Business
The three options for using a 401(k) to start a business are:
1. Use a Rollover for Business Startups (ROBS)
A rollover for business startups (ROBS) lets you invest retirement funds in a new business without paying taxes or early withdrawal penalties. A ROBS is not a loan or withdrawal; instead, it allows you to tap your retirement funds early. There are no monthly payments and no repayment is required, even if your business fails.
How a ROBS Works
A ROBS is a great way to use 401(k) business funding if you have more than $50,000 in qualifying retirement savings. It allows you to use your 401(k) for startup funding. For most business owners, we recommend selecting a ROBS provider to help navigate this complex transaction.
Who a ROBS Is Right For
A ROBS is the best option for 401(k) business financing if you have $50,000 or more in a 401(k) or Traditional IRA and will work for the business full time. Here, a ROBS can be a great way for you to fund the establishment or expansion of your own business without borrowing money or raising equity.
For a ROBS to be a good financing option, you need to:
- Plan to work full time in the business: If you plan on keeping outside employment or investing passively in the business, you will not qualify for a ROBS.
- Have enough retirement assets to start or buy a 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: Using a knowledgeable provider can make the process more efficient and help ensure that your ROBS is compliant.
If you plan to work full time in your business and have enough retirement savings to draw from, you may be wondering what it takes to qualify for a ROBS. While a ROBS provider will determine whether you meet the specific requirements, there are some general qualifications that anyone who pursues this form of 401(k) financing must meet.
A ROBS is not a loan, so there are no loan qualifications. However, to use a ROBS, your business must meet certain criteria. You have to be a C corporation (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.
ROBS for 401(k) business financing qualifications include:
- You have an eligible retirement account: Both a Traditional 401(k) and IRA are eligible, but you cannot use a Roth IRA for a ROBS. Your retirement account must be a tax-deferred account and needs to be over $50,000 to be worth the setup fees.
- Your business is a C-corp: You must have your business registered as a C corporation. This is because the business is selling shares to a 401(k) account. Other legal entities, like an LLC, only allow you to sell shares of the business to real individuals.
- You are a legitimate employee of the business: If you use retirement funds through a ROBS, you must be an employee of the business you are starting for as long as it invests the funds. While there is no set number of hours you need to work, you should work at least 1,000 hours per year in the new business.
There are several 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.
Pros & Cons of Using a ROBS to Start a Business
It is important to consider the benefits and drawbacks of using a ROBS. By using a ROBS to finance your business, you’ll be minimizing the impacts on your business’ cash flow because there is no debt to repay. However, you will end up paying service fees for the setup and upkeep of a ROBS.
Pros of Using a ROBS to Finance Your Business
- A ROBS is not a loan: If you are using your 401(k) to start a business, you can avoid taking out loans. Not only are startup business loans difficult to get, but they carry added interest and monthly payments that could impact the cash flow of your business.
- You can reduce your tax burden: The money from your retirement account is tax exempt, which can help you reduce the tax burden of your business and increase cash flow for reinvestment. This is important in the early stages of a company.
- No impact on personal credit: By using a ROBS to finance your business, you are not taking out a loan of any kind. Therefore, there is no personal credit check needed, and no loan to repay that may impact your credit.
Cons of Using a ROBS to Finance Your Business
- Setup fees increase: Setting up a ROBS is a complicated process that often requires outside help to avoid problems. This often means hiring financial, legal, and tax professionals for help.
- You’ll need ongoing help from experts: ROBS has long-term requirements to ensure your business is in good standing with the IRS. This means you will need to work with legal and tax experts to ensure that the plan is compliant.
How to Set Up a ROBS
To set up a ROBS, you must form a C corporation (C-corp) and establish a 401(k) for that company. Next, you roll over funds from your personal 401(k) into the new company’s retirement plan. Using the funds you rolled over, the new 401(k) plan buys stock in the new C-corp.
If you want to set up a ROBS, Guidant is one provider that guarantees the use of outside counsel if the IRS audits your ROBS plan. It 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 it today for a free consultation.
2. Borrow From a 401(k) or IRA to Start a Business
Those who have a 401(k) can borrow up to $50,000 or half of the vested plan, whichever is less. Loan terms on 401(k) loans are five years with interest paid to your retirement account. You can withdraw funds from your 401(k) for up to 60 days without penalty, provided you fully repay the funds.
You are allowed to borrow money against your 401(k), and even though there are monthly interest payments (around 8%), the interest is repaid in the form of increased contributions to your retirement account. This is a good option if you need less than $50,000; if you need more, a ROBS becomes a much more cost-effective choice.
How 401(k) Business Funding Works
Employers make their own rules for how you can borrow against your account. Some employers limit loans to the contributions you’ve 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 know before attempting to borrow.
The IRS limits borrowing 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 for a maximum of five years, and the interest charged is comparable to a traditional business loan.
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
If your employment ceases while you still owe money on your 401(k) loan, you are still responsible for repaying the loan. You will have until the due date of your next federal tax return to repay the borrowed funds. If the funds have not been fully repaid by the time your federal taxes are due, the remaining amount owed will be treated as taxable income.
How Borrowing Against a Traditional IRA Works
Neither Traditional nor Roth IRAs allow loans like a 401(k) plan may. Both account types permit penalty-free distributions in some circumstances—such as paying for education—but there is no penalty-free distribution for starting or buying a small business.
You can withdraw funds from your 401(k) for up to 60 days without penalty. If you cannot pay the money back within that 60-day window, it will count as a distribution from your account and you will 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
Borrowing against your 401(k) or IRA can be a good option if you are staying with your employer, you will not be a full-time employee of your startup, your business is earning passive income, or you need less than $50,000 in funding. Borrowing can also be best if you need cash now, and can repay in 60 days.
To best protect yourself from penalties and taxes, you will 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 60 days.
Pros & Cons of Borrowing Against a 401(K) or IRA
Before borrowing against a 401(k) or IRA, there are some benefits and drawbacks to consider. Loans borrowed against your 401(k) are easier to get than traditional loans, have better terms, and have lower overall costs. However, you give up the investment interest if the funds were invested and you owe extra taxes.
Pros of Borrowing Against a 401(K) or IRA
- Easy approval: Loans against your 401(k) do not require a credit check or extensive applications. This is an attractive option if you have a low credit score.
- Better terms and costs: Loans are available quickly and carry restrictions on how you use the funds. Interest rates are lower than credit cards, and you get the added benefit of paying the interest to yourself instead of someone else.
Cons of Borrowing Against a 401(K) or IRA
- Opportunity costs: Once you borrow the money, it is no longer invested in financial markets and you cease earning interest on your funds. In addition, you also end up contributing less money to the account while repaying the loan, resulting in a lower balance available for retirement.
- Extra taxes: The wages you used to repay the loan are taxed before you receive them, and then you pay additional taxes on the funds when you withdraw them for retirement.
3. Cash Out a 401(k) or IRA to Start a Business
Cashing out your 401(k) is when you take a full or partial distribution to start or invest in a business. However, if you are 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 are over age 59½ or will have plenty of other retirement savings left over. 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.
How Cashing Out a 401(k) or IRA to Start a Business Works
If you cash out your 401(k) to start a business, you will need to request paperwork from your provider to start the process. Sometimes you can do this online or over the phone. Most of the time, you will need a sign-off from the company that set up your account.
Rules governing cashing out your 401(k) can be restrictive, making the process complex and tedious. If you plan to cash out, expect delays because some plans restrict disbursements to once a quarter or once a year. Once you receive the funds less any fees, declare them as regular income on your taxes.
Who Cashing Out a 401(k) or IRA Is Right For
Cashing out your 401(k) or IRA to start a business is a last resort once you have tried all other options. You will lose out on your funds being in a tax-advantaged retirement account and lose any potential earnings on those funds. It is always the most expensive option.
However, there are two exceptions to this general rule, making cashing out a 401(k) the right business financing option. If you are already at least 59½ years old, or if you have a Roth IRA with a significant amount of contributions that have been in the plan for over five years, then this may be your best option.
Requirements for Cashing Out a Traditional 401(k) or IRA
Cashing out your 401(k) before age 59½ can generate a lot of tax liability and penalties. Contributions made to 401(k) and IRA accounts are made from pretax income. Taxes are charged not in the year you contribute funds, but in the year you withdraw funds.
There are exceptions to the 10% penalty that you may qualify for in either a 401(k) or IRA cash out, but they are not related to starting or buying a business.
The exceptions to the 10% penalty for cashing out your 401(k) include:
- Qualified educational expenses
- Certain medical expenses
- Financial hardship as defined by the IRS
When you cash out your 401(k), you will 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 withhold 20% of the funds and send it to the IRS to cover your federal taxes.
On top of the taxes, you will also have to pay a 10% penalty for withdrawing the funds before retirement age (59½). That is 30% in taxes and penalties right upfront, and you could end up losing more in state and federal taxes. So if you are cashing out $100,000 in funds, you will only get $70,000 and may have some additional tax liabilities to pay off.
Requirements for Cashing Out a Roth IRA or 401(k)
Contributions to a Roth retirement account are taxed in the year the income is earned, and 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 have been in the plan for over five years. However, the earnings within the plan cannot 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 can 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.
Pros & Cons of Cashing Out a 401(k) or IRA to Start a Business
Cashing out your 401(k) may be a good option in certain circumstances. A major benefit is that you avoid the fees regularly charged to your account. You also have freedom in managing your funds. However, you must pay taxes and fees when you cash out, and timing can have a large effect.
Pros of Cashing Out a 401(k) or IRA to Start a Business
- Avoiding annual fees: Your retirement plan has management and administrative fees attached, which you can eliminate by cashing out.
- You’re choosing your investment: Instead of choosing from the selected plans, you can invest your own money into a business that can potentially give you much higher returns.
Cons of Cashing Out a 401(k) or IRA to Start a Business
- Paying penalties and taxes: When you cash out your 401(k), you will be assessed a fee as high as 10%. Your 401(k) is treated as normal income, and will therefore be taxed at your income tax rate.
- Missing out on market growth: Your retirement funds are invested in financial markets, and withdrawals during an economic downturn can cost you a large percentage of your money. You may also miss out on some market growth that happens shortly after the withdrawal.
3 Ways to Fund Your Business With a 401(k) or IRA
Using Retirement Funds With Startup Loans
While the current average 401(k) balance has never been higher, according to Fidelity, it is only $103,700. 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 combine your retirement savings with additional financing in two ways:
- As a down payment to qualify for other financing: If you are looking to get traditional financing, then you may be forced to put 10% to 20% down at closing. You may use your retirement funds as your down payment so you can get approved for the full financing to purchase your business.
- In combination with other financing: If you have a significant amount of money in your retirement account, but it is not enough to start your business, then you may want to use your retirement funds in combination with other financing. 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) does not mean that you cannot 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 is important to follow these rules to avoid paying undue taxes or penalties.
Whether using your 401(k) to start or buy a business is a good option depends on your situation. Cashing out your IRA could work for your startup if you are in the lowest tax bracket. Borrowing against your retirement account could also work if you can repay the funds in 60 days.