This article is part of a larger series on Business Financing.
If you want to use funds in your personal 401(k) account to start or buy a business, you have three options. You can use a rollover for business startups (ROBS), borrow against your retirement funds, or cash out your 401(k) funds.
With a ROBS, you won’t have to pay penalties, taxes, or interest charges against the money used. However, in most cases, you’ll need at least $50,000 in your retirement account to use a ROBS. Meanwhile, loans are limited to half of your vested balance or $50,000, have a limited term, and require you to pay the money back with interest while a cash-out may result in significant tax and early withdrawal penalties and should be considered a last resort.
A ROBS can be complicated, so using a company that can help you through the process is essential. Guidant can help you set up a ROBS. Visit the Guidant website for a free ROBS consultation.
1. Using a Rollover for Business Startups (ROBS)
You can use a ROBS—which is not a loan or withdrawal from your retirement account—to buy or start a business without paying taxes or early withdrawal penalties from your account. You can use funds from your account to fund your new or existing business.
How a ROBS works
For 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 won’t qualify for a ROBS.
- Have enough retirement assets to start or buy a business: You’ll need at least $50,000 in assets to qualify.
- Choose a good ROBS provider: A ROBS is a complicated transaction, so choosing a provider that can walk you through the process is critical.
In addition to having enough retirement assets to qualify for a ROBS, there are additional qualifications you must meet:
- You must have an eligible requirement account: You can use a traditional 401(k) or individual retirement account (IRA) for a ROBS, but you cannot use a Roth IRA. Your retirement account must be tax-deferred with at least $50,000 to be worth the setup fees.
- Your business is a C corporation (C-corp): You must be 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.
Pros & Cons of ROBS
|Access your retirement funds tax-free and penalty-free||Risk of losing retirement funds if the business fails|
|No time in business requirement||Must be a C-corp to qualify|
|Allows for debt-free funding of business for higher monthly cash flows||Must maintain annual requirements to avoid taxes and penalties|
If you want to set up a ROBS, Guidant is an excellent choice. It guarantees the use of outside legal counsel if the IRS audits your ROBS plan. It can even help if you decide to terminate your ROBS in the future. Contact Guidant today for a free consultation.
2. Using a Loan Against Your 401(k) Account
According to the IRS, the maximum amount you can borrow from your 401(k) is 50% of your vested account balance or $50,000, whichever is less. Loans have a maximum term of five years, and payments must be made at least quarterly. You can also withdraw funds from your 401(k) for up to 60 days without penalty, provided you fully repay the funds.
You can borrow against your 401(k), and even though interest is charged, that interest is repaid in the form of increased contributions to your retirement account. If you need less than $50,000 and have the funds to repay the loan, a 401(k) loan is a good choice. However, a ROBS is more cost-effective if you need over $50,000 or don’t have the immediate cash flow to repay a loan.
How a 401(k) Loan Works
IRS rules on 401(k) loans include:
- Loans 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
Some plans may limit what portion of your 401(k) funds you can borrow. Some employers limit loans to your contributions into the plan, while others allow you to borrow against your contributions and the employer’s matching contributions.
If your employment ceases while you still owe money on your 401(k) loan, you’re responsible for repaying the loan on an expedited timeline. You’ll 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 with 401(k) plans. Both account types permit penalty-free distributions in some circumstances, like paying for education. However, there’s 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’ll 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. Borrowing from a traditional IRA is like a short-term loan, provided funds are paid back within 60 days.
Pros & Cons of Using a Loan
|Less complicated than a ROBS||Could face large tax and early withdrawal penalties if money isn’t repaid|
|Interest repaid is increased contributions to your retirement account||Hurts cash flow because you have loan payments to account for|
|Business isn’t restricted to a C-corp; can be organized in any manner||Only an option with 401(k); cannot take out a loan against an IRA|
3. Taking a Withdrawal From Your 401(k) Account
The third option is withdrawing from your 401(k) or IRA. If you’re younger than retirement age (59 1/2), any nonqualifying distributions are subject to income tax and a 10% penalty.
The IRS has a list of exceptions that exempt you from the 10% penalty. Those include:
- Qualified higher education expenses
- First-time home buyers up to $10,000
- Some unreimbursed medical expenses
If you’re older than 59 1/2 or have a Roth IRA with a significant amount of contributions that have been in the plan for more than five years, it might make sense to cash out to buy or start a business.
How a Withdrawal From Your 401(k) Account Works
Cashing out your 401(k) before 59 1/2 can cause significant tax liabilities and penalties because contributions to 401(k) and IRA accounts are from pretax income. Those taxes aren’t charged until you withdraw the funds.
You’ll have to pay federal and state taxes on the amount you withdraw as gross income for that year, which could also place you in a higher tax bracket. Your plan administrator will withhold 20% for federal taxes. Combined with the 10% penalty, you’ll lose 30% of your withdrawal immediately in taxes and penalties.
With a Roth IRA, those contributions are taxed in the year the income is earned. All contributions after 59 1/2 are tax-free as long as your plan is at least five years old. After five years, you can withdraw your contributions but not the money earned from those contributions. Any contributions withdrawn before 59 1/2 will be subject to the same 10% penalty.
As always, consult your financial advisor before withdrawing cash from your retirement account to understand the tax implications.
Pros & Cons of Taking a Withdrawal
|Can potentially get a larger sum of money without having to repay a loan||Can face substantial tax liabilities and penalties for early withdrawal|
|No restrictions on how your business is organized||Could place you in a higher tax bracket, causing a larger tax burden|
|Funds could be used for both personal and business expenses||May be risking your future ability to retire if the business fails and retirement funds are lost|
Alternatives To Using a 401(k) to Start or Buy a Business
If you’re unable to use your 401(k) funds to buy or start a business, you may want to consider other ways to get your business started. Here are some alternative funding options:
- Home equity loan (HEL) or home equity line of credit (HELOC): If you don’t have business income or credit built up, these would allow you to use built-in equity in your primary residence to fund a new business.
- Personal loan: If you have good personal credit and a strong income, you may be able to get a personal loan to fund the purchase of your business.
- Friends and family: Members of your family may be able to loan you money to start or buy your business. Make sure these are classified as loans to avoid any tax issues.
- Crowdfunding: Using a crowdfunding platform can allow you to sell items or rewards in exchange for funding for your business.
Frequently Asked Questions (FAQs)
Can I use my 401(k) money to start a business?
Yes, you can use funds from your 401(k) to start a business. If you have at least $50,000 in your retirement accounts, you can use a rollover for business startups (ROBS) to buy or start a business. You can also take out a loan against your 401(k) as long as your cash flow supports the payments to repay the loan. The final option is to take a withdrawal from your 401(k), but that can come with significant tax liabilities and penalties.
Can I use my 401(k) to buy a business without penalty?
There are three ways to use 401(k) funds to buy a business without penalty:
- Rollover for business startups (ROBS).
- 401(k) loan.
- Roll over your retirement to take 80% of the funds from the account and repay them to the same account within 60 days. This is the riskiest because you open yourself up to tax liabilities and penalties if the funds aren’t repaid.
How much of my 401(k) can I use for ROBS?
You can use as much of your 401(k) as you want for ROBS, but you usually need to roll over at least $50,000 to get a ROBS started. You can use an additional rollover capital (ARC) transaction to add retirement funds to your ROBS later on. Be sure to choose a great provider when considering a ROBS, as it’s a very complex transaction.
Using your 401(k) funds to buy or start a business is a great way to avoid taking excessive amounts of debt when starting your business. However, because you’re putting your retirement funds at risk, it’s important you work with a financial advisor throughout the process to help mitigate any long-term personal financial risk.
If you decide to choose a ROBS, choose a great ROBS provider like Guidant to help you through the process. Guidant can guide you through this complex transaction and help you buy or start your new business.