You can use your 401k or IRA to start or buy a business in three main ways: cash out the funds, borrow against them, or use a rollover for business startups (ROBS). The only 401k business funding option that doesn’t result in penalties, taxes, or interest charges is a ROBS, making it an excellent way to tap into your retirement account.
A ROBS allows you to rollover your 401k or IRA to buy a business, without any penalties or immediate tax obligations. If you have $50K+ in your retirement account you can use it to start or buy a business. Speak to Guidant for a free ROBS consultation.
3 Ways to Use Your Retirement Funds to Start a Business
|Rollover for Business Startups (ROBS)||If you have $50K+ in an eligible retirement account, and are planning to be a full time employee of the new business.|
|Cash Out Your 401k (or IRA)||If you’re willing to pay the taxes and early withdrawal fees, and need quick access to funding.|
|Borrow Against Your 401k (or IRA)||If you expect to receive a large amount of money within 60 days, but need the funds now.|
Whenever you start a business there are numerous risks. If you need financing to start that business the risks increase. Borrowing to start a business typically requires you to sign a personal guarantee, putting your personal assets at risk. In some cases, using savings from a 401k to start a business can be less risky since the only thing at stake is the funds you put into the business.
You can typically use your 401k or IRA to start or buy a business in three different ways:
1. Use a Rollover for Business Startups (ROBS) to Start a Business
A Rollover for Business Startups (ROBS) invests your retirement funds into your business without paying any taxes or early withdrawal fees. A ROBS is not a loan or a cash out of your retirement account, but is a great 401k business funding option. There are no monthly payments on a ROBS, and no requirement to pay the money back, even if your business fails.
ROBS funds can be used for a business acquisition, as working capital, as a down payment on additional financing, or for any other business purpose. 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.
In order to use a ROBS, you must pass a few requirements, which include:
- Eligible Retirement Account: Both a 401k and traditional IRA are eligible, but a Roth IRA cannot be used for a ROBS. Your retirement account must be a deferred tax account, and typically needs $50K+ to make it worth the setup fees.
- Business is a C Corp: You must be willing to have your business registered as a C Corporation. This is due to the business selling shares directly to a 401k account. Other legal entities, like an LLC, only allow you to sell shares of the business to real individuals.
- Full Time Employee: You, or whoever’s retirement funds are used, must be a full time employee of the business for as long as the funds are invested. It’s not a good fit for passive businesses, like real estate investing, or to invest in a friend or family member’s business.
There are a number of administrative rules and regulations that you must also 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.
According to Joseph B. Hogan, Associate Financial Planner at RTD Financial, a ROBS is even a good option if you’re planning to start a business in the future:
“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.”
When to Use a ROBS
A ROBS is likely the best option if you have $50K+ in your 401k or traditional IRA, and are going to work full time in the business. If you plan on retaining your full time job while someone else runs your business, then you won’t qualify for a ROBS.
A ROBS is also a good option if you have enough in your retirement account to start or buy your business. This will help you finance your business without having to take out a loan, and not requiring your business to take on debt payments. However, a ROBS can work well with additional financing as well, lowering your overall debt.
If you’re going use a ROBS, we recommend using a partner that is well experienced at setting ROBS up and administering them. Our recommended provider is Guidant, but you can learn more about how the best providers stack up against each other by reading our ROBS buyer’s guide.
Guidant is the only provider we’ve reviewed that guarantees the use of outside counsel if the IRS audits your ROBS plan. They will help you through the whole process and give you expert advice on setting up your plan and guide you through administering it afterwards. You can call them today for a free consultation.
2. Cash Out Your 401k or IRA to Start a Business
Cashing out a 401k or IRA before age 59 ½ will result in large tax payments around 20% on the amount you withdraw, plus pay an additional 10% penalty. This is likely the most expensive option to access your retirement funds.
Cashing out your 401k can also have a long-term impact on your retirement savings. There are annual contribution limits for your 401k account, so you can’t just pay the funds back into your retirement account later. You’ll miss out on all of the years those funds could be compounding, too.
Even if the business you put your cash-out retirement fund toward is profitable, those profits are taxed each and every year. A perk of using a ROBS over cashing out a retirement account to start a business is that your contributions continue to grow in a tax advantaged retirement account.
Cash Out Traditional 401k or Traditional IRA
Cashing out your 401k before age 59 ½ can create a lot of tax and penalty obligation. Contributions made to 401k 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 401k 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. 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 (59 ½). 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 $100K in funds, you’ll only get $70K 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 401k or IRA cash out, but none of them are related to starting or buying a business.
Cash Out Roth IRA or Roth 401k
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 59 ½ are made without tax obligations, as long as your plan is at least 5 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 5 year test, meaning the contributions qualify if they’re in the plan for 5+ years. However, the earnings within the plan can’t be taken out before age 59 ½ without paying taxes and penalties.
For example, if you put $20K into your IRA in 2017, then you’ll be able to withdraw that $20K tax and penalty free at the end of 2021, but any money that $20K has made is not eligible. Using a Roth IRA to start a business may be ideal if you have a large amount of contributions that have been in your retirement plan for at least 5 years.
When to Cash Out Your 401k or IRA
Cashing out your 401k or IRA to start a business is typically a last resort choice, once you’ve exercised all other options. You’ll lose out on your funds being in a tax advantaged retirement account, and lose any potential earnings those funds could grow into. It’s almost always the most expensive option.
However, there are two exceptions to this general rule, making a cash out the right 401k business funding option. If you’re already at least 59 ½, or if you have a Roth IRA with a significant amount of contributions which have been in the plan for 5+ years, then this may be your best option.
3. Borrowing Against Your 401k or IRA to Start a Business
Borrowing against a 401k or IRA to fund a startup or business acquisition will require you to make debt payments with interest. Those payments are due regardless of how your business is doing. In the case of a 401k, the payment will be made via payroll deduction. If you default on your 401k or IRA loans then you’ll be taxed and penalized like you would under the cash out option (taxed as gross income and charged a 10% penalty).
Borrowing Against Your 401k
According to a study by Aon Hewitt, around 26% of all 401k 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 loan against both your contributions and the matching contributions your employer has made. Each plan has it’s own rules that you must be aware of before attempting to borrow.
According to Ryan Miyamoto, CFP, MBA, from Second Level Wealth:
“Your best option for using your retirement funds to start a business may be to take a loan, however the fine print is very important. If you’re starting your own business then there’s a chance you’re leaving the company that holds your 401k. If you are, you need to verify, and then verify again, that you can keep your 401k when you leave and take a loan.
This is rare, because even the plans that allow you to keep the 401k will typically withdraw the loan feature of the plan when you leave the company. This means you could be hit with plenty of taxes and penalties due to the withdraw, unless you’re able to pay it back in about 60 days.”
The IRS limits how much you can loan from your 401k account to the lesser of either $50K or half of your vested balance in your plan. The loan term is generally for a maximum of 5 years, and interest is charged that 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.
Borrowing Against Your Traditional IRA
Neither Traditional or Roth IRA’s allow loans like a 401k plan may. But 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.
What you can do with an IRA is take a very short term loan from your account that will last 60 days. If you fail to pay the money back within that 60 day window then 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 1-year period.
When to Borrow Against Your 401k or IRA
Borrow against your 401k 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 $50K in funding. It could also work if you know you’re getting 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 401k if you separate from your employer. The minute you separate from your employer or move your 401k funds, the loan will come due within about 60 days.
Combining Retirement Savings with Additional Funds to Start a Business
While the current average 401k 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.
Common Types of Additional Financing
There are 4 main types of additional financing that can be used along with your retirement funds, and the four most common are:
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.
SBA loans are also often amongst the cheapest loans you can get with lower interest rates (6-9%) and longer terms than other forms of financing. You can learn more by reading our article on how to apply for an SBA loan.
HELOC (Home Equity Line of Credit)
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 that total equity.
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.
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 $20K), and they carry APRs from 15-30%.
Your 401k 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 401k 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.