Should You Finance a Business With Your 401(k)?

Launching a business takes money, and many entrepreneurs have turned to their 401(k)s to provide startup capital in recent years, The New York Times and Reuters report.

Bypassing the banks by using your 401(k) can be a complicated and risky move. But if you’re considering a new business venture and have ample funds in your retirement account, there are plenty of good reasons to invest in yourself instead of the stock market. If you want to avoid having to answer to creditors, are afraid of taking on debt that could bankrupt you, or don’t want to be forced to share a stake in your business with investors, using your 401(k) to finance your business may be a good solution.

Before you dip into your 401(k) in this unconventional way, here are a few things to consider:

  1. Do you understand the tax implications? If you are younger than 59 1/2 and withdraw money from a 401(k), you will pay income taxes and a 10 percent penalty for taking your money out early. You can legally avoid this penalty and invest your 401(k) in your new venture by using a method called a Rollover-as-Business Startup. To use ROBS, you’ll need to create a C-corporation, which will sponsor another 401(k) that you can roll your retirement money into to provide the company with operating funds. However, Bankrate warns that this tactic is an IRS gray area, so you’ll want to get proper legal guidance to ensure that you comply with federal tax rules.
  2. Will you be able to pay yourself back? One alternative to using ROBS is to borrow from your 401(k) for the business — and then pay yourself back. These loans are limited to the lesser of $50,000 or 50 percent of your vested balance and must be paid back within five years, amortized quarterly. You may end up with a big tax bill if you are unable to pay back the loan. Of course, even if you don’t use this method of financing, you should plan to replenish any 401(k) money you use for your business, so you’ll have it when you retire.
  3. Do you have a solid plan for making the business successful? USA Today warns that using a 401(k) to fund a business multiplies the risk entrepreneurs always take when starting a company. If the business fails, you not only lose retirement income, but also give up any compound interest you would have earned if your 401(k) was invested in other assets that increased in value.
  4. Have you exhausted other viable funding sources? Because of the risk to your financial future and the complicated legal steps involved in taking money out of a 401(k), StartupNation advises that entrepreneurs view 401(k) funding as their last resort.

The benefit of using your 401(k) money, of course, is that you can avoid other investors having a claim on your business and borrowing from other people you have to pay back. Still, the business you’re starting needs to be worth putting your future financial security at risk.

About Christy Rakoczy

As a full-time freelance writer specializing in business, legal, and financial writing, she has published both textbooks and web content for major publications. She and her husband split their time between Florida and Pennsylvania.
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1 comments
ericlng
ericlng

When we started our business we had the option of using some money from our 401, but we instead used money from our personal savings....a lot!  Now that we have good cash reserve, is there a way to pay ourselves back like a loan payment and if so is there a tax advantage to doing so, instead of classifying it as a draw or maybe even payroll???

 

thanks