How to Use a 401(k) to Start or Buy a Business

Cody Cromwell
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3 Ways of Using a 401(k) to Start a Business

401(k) plans are a very flexible and effective method of starting a business. If you have 401(k) funds, there is a good chance that you are also a business owner, but there are also two ways in which 401(k)s can be used to start a business: 1) owning a business and 2) becoming an employee of a business that you own.

The tax benefit of contributing to a 401(k) plan in this manner is that you can withdraw the funds to invest in your new company once you are done with your services. With other methods of financing a business, the 401(k) can only be withdrawn if the business is sold before your retirement. Of course, if you are taking the money out of your 401(k) and owning your own business, it can be withdrawn at any time for any purpose.

If you decide to use a 401(k) to start a business as an employee, you will need to make sure that you are well taken care of financially while you are with the company to avoid any lawsuits.

Use a Rollover for Business Startups (ROBS)

Attorney General Scott Pruitt is rolling back an Obama-era lawsuit against the Financial Services Industry, which could result in 401(k) laws being weakened. In the suit, the Obama Administration has been suing several companies, and the companies have been volunteering to settle under confidential terms. The companies and the Obama Administration have been arguing over whether the companies are required to allow rollovers of 401(k) plans into individual retirement accounts (IRA) or the right to roll over after the retirement age of 59-1/2. A rollover of a 401(k) into an IRA is a good way for a small business owner to start retirement savings and would allow the money to be invested in more passive, low-risk investments. This is a good time to look for a business opportunity or start a business without the stress of traditional debt. You can select a company like the Motley Fool to invest in, or you can start a small business with most of your savings and loans, without having to make payments for the next five years.

A change in IRS regulations could be a good opportunity to impress investors with a business idea or to start a much needed business.

How a ROBS Works

It is common for small business owners to set aside funds for their retirement, especially if they usually have a full-time job. In fact, some employers elect to match a portion of an employee’s 401(k). The employee commonly contributes to this 401(k)

Additionally, some companies will allow or even encourage employees to contribute to their own 401(k) rather than an employer’s 401(k). For example, an employer may allow employees to contribute up to 10% of their income to their 401(k). If the employee wants to set aside more money for retirement, they can contribute up to 15% of their income.

This is an advantage to accepting a Robs. If an owner elects to set aside 10% or 15% into their 401(k) and the business has a ROBS, the owner will also have the opportunity to use that ROBS when purchasing a busine$$.

ROBS…a Robust Option for Small Businesses

In some cases, an ROBS may offer a business owner and their business a robust option to secure their own retirement. Most companies that offer ROBSs charge an upfront fee or a monthly fee. The business owner must decide whether they should raise the necessary funds from their 401(k) account or use a Robs.

Who a ROBS Is Right For

ROBS Qualifications

According to the IRS information page, the following types of investment income are not considered earned income for the purposes of this Roth account:

  • Interest on deposits, including bank money market deposits, savings accounts, and time money market deposits
  • Taxable interest
  • Dividend income
  • Capital gains
  • Reinvestment interest
  • Borrowing expenses
  • Mortgage interest
  • Unrelated business taxable income (UBTI), otherwise known as sole proprietorship or pass-through income
  • Patronage dividends
  • Direct selling expenses
  • Rental income
  • Barter income

Any taxable compensation (i.e., salary, fees, commissions)

The Roth 401(k) is more flexible than a Roth IRA because you can withdraw money penalty-free on a qualified distribution in the following instances:

  • If you become disabled
  • If you are over age 59½ and have not performed any three qualifying events
  • If you become unemployed
  • When you leave a job and have eligible rollover distributions due to at least five-consecutive years of employment with a qualified employer
  • If you return to work for the employer within a year of distribution
  • If you become totally and permanently disabled
  • If you die
  • If you pledge your Roth 401(k) to pay medical expenses
  • If you pledge your Roth 401(k) to pay certain taxes and penalties

Pros & Cons of Using a ROBS to Start a Business

Most new business owners dream of the ideal scenario: They pay rent, they have enough money to pay everyone, they don’t have to worry about how much money they’ll have at the end of the month, a little extra money every month goes towards savings, and they have enough money to live comfortably.

In most small businesses, the owner or somebody else in the business is taking home wages, and the business is paying the bills. With a ROBS, the business’s bank account is technically the business’s bank account, and it’s the business’s money.

Since it’s company money, the business can pay employees, buy equipment, and put money into savings and retirement. The ROBS makes the business independent, and the business is no longer reliant on the person serving as the –employer.”

How to Set Up a ROBS

Starting a business can be an exciting venture, but it can also be overwhelming. Retirement plans, such as 401(k)s and 403(b)s, can offer some benefit to entrepreneurs through the opportunity to save for retirement while pursuing your entrepreneurial dream. The downside is that these plans are not designed for use as retirement accounts … they are set up differently and different rules govern how they can be used. Some planners recommend the most common type of plans, 403(b)s and 401(k)s, but some attorneys recommend against taking money out of these plans because of the risks.

Still, these plans can be used to help entrepreneurs get through many of the tough times that come with starting a business, and it can be helpful to know the rules for using them to start and build a business.

Borrow From a 401(k) or IRA to Start a Business

If you have an employer-sponsored retirement plan, such as a 401(k) or an individual retirement account (IRA), consider borrowing from it. It may be a smart move for a number of reasons.

One of the most common reasons people use a 401(k) or IRA to start a business is because they have an extended break between leaving their job and taking care of their day-to-day financial obligations. Borrowing from a retirement plan can help you bridge the gap, allowing you to get started without the expenses and complications that would take place if you took out a loan.

Another common reason why people borrow from a 401(k) is to help start a business. Say your 401(k) has a policy that the account balance will be rolled over to an IRA after you leave your job. By taking out a loan from your 401(k) rather than an out-of-pocket sum, you can transfer all of your retirement account assets to your new business without the tax hassle and risks associated with an IRA or 401(k) withdrawal.

A third common reason is that borrowing from a retirement plan offers a tax deduction for the contribution to the plan. This deduction is the same as if you took out a loan from a bank or other financial institution.

How 401(k) Business Funding Works

How Borrowing Against a Traditional IRA Works

In addition to its paycheck, you also receive a regular paycheck from an employer, and that paycheck has one purpose…to pay the bills. Part of that paycheck also goes into an employee’s 401(k) retirement savings plan.

But what happens when you start your own business? Even if you have a business partner or two, you’re pretty much all you have. That means you have to fund the business on your own.

One way to fund your business is to take out a small business loan and use that to purchase inventory and other business-related products. But another way to fund the business with little to no personal investment is to use a 401(k) plan.

An exception to this is if you are a high-earning employee of a large corporation where you’re treated like a millionaire. If that is the case, your employer will likely substitute a 401(k) plan for a traditional IRA. But for others, a 401(k) may be the best option for funding their business.

Who a 401(k) or IRA Loan Is Right For

The IRS considers a 401(k) or IRA loan to be a loan and not a gift, so the APY on the loan will be taxed.

And because the loan must be repaid with interest, these loans are generally used for small business owners to purchase a piece of property or for other purchases they would be unable to make otherwise.

401(k) loans are also good for people who don’t want to be in business for themselves but are looking to get into a more entrepreneurial position. They allow you to acquire a business idea or start-up and put money aside for future use.

One thing to keep in mind is that as with any debt, loans can negatively affect your credit score.

If you put your 401(k) or IRA on a loan, they will be restricted so you cannot make any new contributions, and all earnings will be deposited into your loan.

So to be clear, you should not use your 401(k) or IRA to pay for day-to-day expenses. Additionally, funds left over from borrowing from these accounts should not be used for month-to-month living expenses.

You should be able to sleep well at night knowing that your loans are being managed and are helping your business keep moving forward, and not destroying your financial stability.

Pros & Cons of Borrowing Against a 401(K) or IRA

The popular stereotype is that wealthy people are lazy and unwilling to work for their money. This is not true for most wealthy people, but that’s also not true for all poor people. There are different skill sets that wealthy people have, and they are interested in learning new things. Some of them go and get an MBA, some study motivational speaking, some dive into investments and some perform as comedians. But none of these things will give a person enough money to be able to retire and live off a reliable pension.

This part of the article is going to focus on the borrowing against a 401(k) or an IRA topic as it relates to the different options that an investor has when they are looking at borrowing against their retirement account. I want to focus on borrowers who are able to qualify for some great loans and who want to insure that they are making the right investments for their financial future.

For Ownership versus Stock Investors

Borrowing against a retirement account can be considered a bit tricky topic, and so it’s even more important that you are doing it correctly. For investor who are looking to borrow against their retirement account, they should expect a higher interest rate than they would if they were borrowing against current income. The higher the rate the better, but some investors are just looking to pay off some bills and so are willing to accept some short term pain to achieve their long term goals.

Cash Out a 401(k) or IRA to Start a Business

If you’re planning to launch your own business, you might want to consider the options that are available to you through your retirement savings. You can rollover 401(k) money or rollover a traditional or Roth IRA into an LLC or a business. This flexibility allows you to choose the method that best fits your circumstances. Some of the following scenarios are covered below.

What Are Your Options?
You can only rollover a 401(k), Traditional IRA, SEP IRA, SIMPLE IRA, or a qualified plan to an account in a qualified retirement account. These are called IRA rollovers.

This flexibility allows you to take the money out without penalty and use it to start a business. You don’t need to pay income taxes at the time of withdrawal. The money can be held in your traditional or Roth IRA for up to five years. Then, you can transfer the money into any one of the following: an LLC set up by you or your spouse as a business owner, a different IRA, or a 401(k)/403(b) plan.

Caution: Some of these options include mandatory distributions age 70 1/2, a survivor’s benefit, and hefty early withdrawal penalties.

How Cashing Out a 401(k) or IRA to Start a Business Works

When do you get to start using your retirement funds? This is a big question with a few different answers. First, let’s get the most common one out of the way. The default answer to this question is that you can’t withdraw funds without some kind of penalty.

But technically, that’s not true … you have to pay a 10% penalty if you are under 59 1/2, and it was a mistake, you can withdraw funds penalty-free at any age before age 59 1/2 if you are using the funds to start your own business.

The 401(k) and similar programs do not technically prohibit withdrawal before age 59 1/2, but the catch is, you have to pay a 10% penalty unless you are starting a business or making a life-changing move. If you hit the age of 59 1/2 or 65, then you’re out of luck.

If you pay the penalty, then you can’t withdraw until age 59 1/2. But, if you use the money to start a business, then you can withdraw money penalty-free at any age.

The second common answer starts with the statement that, if you start a business while you are still working, then there are certain guidelines that regulate how fast you can withdraw money.

Who Cashing Out a 401(k) or IRA Is Right For

A 401(k) is a type of retirement plan that is fairly popular among upper-middle class and upper class households. As with all retirement plans, it is a tax-deferred retirement account in which you contribute pre-tax dollars and then invest them in mutual funds before withdrawing them at retirement.

Contributions to a 401(k) account can be taken each year, including company matching contributions. With a 401(k), you can also take a loan from your account and pay it back later.

The great thing about a 401(k) is that you can take any amount of money out of your account as needed for retirement. If you’re paying off a mortgage and you need a large down payment for a new or used home, you can take money out of your 401(k) to supplement your down payment and protect yourself from taking on unnecessary debt.

A 401(k) can also be used to buy a business. There are no restrictions on how many dollars you can take out of your 401(k). Because there are no restrictions, there is typically no penalty to leaving the company that provides your 401(k) plan. Plus, you are free to change employers without losing your 401(k) money if you so choose.

If you have a 401(k) and want to start or buy a business, take the next steps listed below.

Requirements for Cashing Out a Traditional 401(k) or IRA

Your 401(k) or IRA probably contains quite a bit of money, and if you’re thinking of starting a business, you’re probably also looking at all of that as liquid investment capital.

Interesting thing about those retirement accounts is that there is a special rule allowing you to take money out before retirement age, and that money will be taxed in your tax bracket today.

Note that if you have any individual retirement accounts like an IRA (Individual Retirement Account), your income tax rate when you withdraw money from your IRA is determined by the income tax bracket that applies on your compensation and modified adjusted gross income (MAGI), not on the investment income.

In other words, the tax rate on your 1099-R, and any income from other sources, takes precedence over the tax rate on your IRA.

There are no restrictions on the amount you contribute to a 401(k) or traditional IRA. Since the limit on 401(k) contributions is set for the year, if you wish to cash out your 401(k), you could do a direct transfer from your IRA to your 401(k), but the IRS counts this as a taxable distribution. For this reason, you should think twice before doing this, and you should consult a professional if you are considering it.

Requirements for Cashing Out a Roth IRA or 401(k)

If you’re interested in cashing out a retirement account for the purpose of helping to start a small business, good for you! As an entrepreneur, it’s important to put your money where your mouth is and start saving early. This allows you to invest your money and have a plan on how you’ll use it. And beyond your retirement nest egg, saving your money in a Roth IRA (or an IRS Roth 401(k)) is an opportunity for you to use your hard earned cash tax free.

If you are cashing out your Roth IRA or your Roth 401(k), you’re going to pay tax on the amount that you take out. But you should consider the trade-off: facing a tax bill now in exchange for tax-free withdrawals in retirement.

So once you start saving in a Roth IRA, or a Roth 401(k), make sure you don’t break the plan. However, there are situations in which you may need to cash out your Roth IRA or Roth 401(k) for a business, such as buying a car or starting a small business. That’s okay as long as the total value of all the withdrawals does not exceed your total contributions.

Pros & Cons of Cashing Out a 401(k) or IRA to Start a Business

If you’re considering taking money from your retirement savings to start a business, you’re certainly not alone. In fact, you’re one of more people that are taking this course of action than ever before.

Experts have been pointing out the potential benefits of such a course of action for some time now. As a matter of fact, a recent study by the Financial Industry Regulatory Authority (FINRA) revealed that almost 40% of advisors are currently recommending their clients to take funds from their 401(k) or IRA and use it to start a business.

With such a low price tag, this type of course of action seems like it could be a great short-term or long-term solution. But before you do take the plunge and do it yourself, it’s important to carefully consider these key points:

Pros

Allows you to quickly begin generating income.

The capital is free from income tax, saving you significant amounts on taxes.

Relatively painless to access funds, as there’s no income tax to withdraw the funds.

Cons

Depends on the plan’s rules. Plan termination can disqualify you.

You lose your employer match.

The risk of losing the plan to bankruptcy or unpaid distributions.

3 Ways to Fund Your Business With a 401(k) or IRA

Using Retirement Funds With Startup Loans

I have a client who is in her 20s and wants to open a fitness center. She understands that the business will take a few years to build, so she is willing to wait. But she has a family to support and is doing some research.

She wants to know if she can borrow against her 401(k) when starting up a business and use it to buy equipment. She also wants to know if other retirement funds can be used to start a business and if those funds can be borrowed against when starting a business.

If you answered yes to these questions, you’re not alone! There are a lot of restrictions on what can and cannot be accessed through a retirement account, but there are ways to put money into a business or access funds from your retirement account to start a business. Here’s a summary of the regulations and other relevant information.

Bottom Line

If you are starting your own company or expanding the business you already own, planning to take equity or a loan or have good equity, 401k is an important option. You can use borrowed money or cash from your 401k plus your salary to start your business. You can use sales from your business to retire or start a new business.

If you’re reading this, you most likely started your business to start a lifestyle business that you can continue doing even as you grow older. This will require you to live off the income from your business and not depend on social security.

Review Your Options First

Although the options for retirement can seem overwhelming, by taking a few minutes to review your options first you can easily see the value of 401k.

Don’t Wait until Your Baby Is Born

To take your retirement plan when you leave your job you have to wait until your baby is born. But if you start your business before you leave, you can take your retirement plan before you leave your job and roll it into your business. This will then count towards your total contributions to your business and you can figure out what you can fit in the 401k.