This article is part of a larger series on Business Financing.
There are three ways you can use your 401(k) to start or buy a business. You can cash out funds, borrow against your 401(k), 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 individual retirement account (IRA) with no penalties or immediate tax obligations. If you have at least $50,000 in your retirement accounts, Guidant will offer a free ROBS consultation.
3 Ways of Using a 401(k) to Start a Business
Rolling your 401(k) into new business funding without penalties
Borrow Against IRA
Borrowing without fees for 60 days
Cash Out 401(k)
Last resort 401(k) funding
Use a ROBS
A ROBS lets you invest your retirement account in a new or existing business without paying taxes or early withdrawal penalties. A ROBS is not a loan or withdrawal from your retirement, but it allows you to tap your retirement funds to fund your new or existing business. If you decide to utilize a ROBS, we strongly recommend selecting a ROBS provider to help navigate this complex transaction.
How a ROBS Works
A ROBs makes sense for individuals with over $50,000 in retirement assets who intend to work in their business full time. A ROBS can be a great way 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:
- 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.
Some additional ROBS 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 more than $50,000 to be worth the setup fees.
- Your business is a C corporation: You must have your business registered as a C-corp. This is because the business is selling shares to a 401(k) account.
- You must offer a retirement plan to eligible employees in your business: A ROBS provider will help you set up and, in many cases, administer a retirement plan for your eligible employees.
If you want to set up a ROBS, Guidant is one provider that guarantees the use of outside legal 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 Guidant today for a free consultation.
Borrowing 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 also 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 of around 8%, the interest is repaid in the form of increased contributions to your retirement account. If you need less than $50,000, borrowing against your 401(k) makes sense. A ROBS is a more cost-effective choice if you need more than $50,000.
How Borrowing Against a 401(k) Plan Works
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
Employers may also establish 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 employer’s matching contributions.
If your employment ceases while you still owe money on your 401(k) loan, you are responsible for repaying the loan on an expedited timeline. You will have until the due date of your next federal tax return to repay the remaining balance owed. 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 IRA 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. In this case, borrowing from a traditional IRA is very much like a short-term loan, provided funds are paid back within 60 days.
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. If you are under retirement age (59 1/2), any nonqualifying distributions are assessed income tax and a 10% penalty. Qualifying distributions include things like 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.
However, there are two exceptions where cashing out a 401(k) becomes an acceptable financing option. If you are at least 59 1/2 years old, or you have a Roth IRA with a significant amount of contributions that have been in the plan for over five years, cashing out may make sense.
If you cash out your 401(k) to start a business, you will need to request paperwork from your provider to start the process. This typically can be requested online or over the phone.
Implications of Withdrawing From a Traditional 401(k) or IRA
Cashing out your 401(k) before age 59 1/2 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.
These exceptions 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 taxes, you will also have to pay a 10% penalty for withdrawing funds before retirement age (59 1/2). This yields an initial 30% in taxes and penalties, with the potential for additional tax liability at year-end.
Implications of Withdrawing From 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 59 1/2 are made without tax obligations as long as your plan is at least five years old. Similar to traditional retirement plans, cashing out your Roth IRA before that age will cost you a 10% penalty on all earnings within the plan.
For example, if you put $20,000 into your IRA in 2019, then you can withdraw that $20,000 tax- and penalty-free at the end of 2023, 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.
Using Retirement Funds With Startup Loans
While the current average 401(k) balance has never been higher, according to Fidelity, it is only $123,900. This amount may not be enough to start or buy the business you want, and you may need additional financing. Small Business Administration (SBA) loans are a popular source of financing for businesses; however, many business owners also utilize personal funds to help get the financing they need.
You can utilize your retirement funds as part of your financing needs. Most lenders will require 20% of the loan package as a down payment. However, if you have sufficient funds available without significantly impacting your retirement account, you can lower your total debt and monthly payments by adding additional money down.
If you are considering using part or all of your 401(k) to buy, start, or expand a business, it’s important to know the options available and the tax consequences of those options. A ROBS conversion of your retirement account is preferred if you have at least $50,000 available. Withdrawing from your traditional 401(k) or IRA should only be considered as a last resort or if you are age 59 1/2 or older and are willing to claim the withdrawal as taxable income.