Many entrepreneurs report that getting financing for a new startup business is more difficult than ever before, especially for business owners without a proven track record for success. With those challenges in mind, it’s not hard to see why leveraging a 401(k) retirement account to fund a new business venture can sound like a good idea. Thousands of Americans are doing it. But some prosper and others fall flat — is using your retirement account to fund a new business worth the risk?
Two methods to fund a business with a retirement account
Your 401(k) retirement account can finance your business two ways: either with a loan or by rolling over your balance into a new 401(k), called a Rollover as Business Startup (ROBS).
Here’s what you need to know about choosing to use your retirement account to fund your new business — or whether it makes sense to choose a different path to get the funds to need to get your venture off the ground.
Option No. 1. Taking out a 401(k) loan
If your 401(k) plan permits loans, the IRS allows you to borrow up to half of your vested balance or $50,000, whichever is less.
Unlike traditional small business loans, there’s no actual interest fee involved in borrowing against a 401(k) plan — in the sense that you’re not adding to whatever you’re taking out to pay back later. And there’s no lender involved, either, so people with a negative perception about debt or who don’t want to have their credit report run might prefer to avoid involving a bank or other third party.
What you need to weigh to figure out if there’s a cost advantage are potential accrued investment gains that you’ll be missing out on by withdrawing the cash versus the interest rate that you’d pay on a traditional business loan. For instance, if you’re in a year in which you earn 5 percent on your 401(K), but you’d have a loan for the same amount you’d withdraw from your savings at the same 5 percent, it could be a wash. (At the same time, in a down-market year, you also could potentially be avoiding losses.)
And, although there’s no interest to borrow against your 401(k) plans, they do require modest loan fees, including origination and administration costs, as well as a 10-percent early withdrawal penalty if you’re under age 59½.
In addition, some plans have restrictions on what funds can be used for. And the big clincher: if you fail to pay the loan back within the loan term, usually five years, you will pay income tax on the entire balance of the money taken out.
Option No. 2. Rollover as Business Startup (ROBS)
To avoid the 10-percent early withdrawal penalty, some startup entrepreneurs take a different form of 401(k) financing known as a Rollover as Business Startup (ROBS). The process is a bit complicated, but many are using it to their advantage. To do this type of 401(k) withdrawal:
- Create a C-corp with its own 401(k) plan.
- Roll over the funds from your existing 401(k) into your new corporation’s 401(k).
- Your new corporation issues stock and your new 401(k) invests in the corporation by buying its stock.
- The money used to buy the stock becomes a source of capital for your new corporation.
This money can be used to start a new business or buy an existing business.
On the flip side, however, ROBS is a complicated process and requires a rollover plan provider to ensure proper setup. (That’s in bold for a reason!) The provider will require fees for setup and maintenance for the life of your business, usually from $800 to upward of $1,450 annually. And, unlike other 401(k) loans, the funds can’t be used to pay owners’ salaries.
There are also multiple considerations with the Internal Revenue Service (IRS). The IRS has strict compliance standards to avoid penalties (and audits). Administering a 401(k) plan — including educating employees about the plan and allowing them to participate — is a complex job requiring time, effort and knowledge. Given this, you need to consider whether you’re up for the potential risk of this level of increased scrutiny.
So, should you fund your business with a retirement account? The verdict.
There’s one major potential drawback of funding your business with a retirement account — regardless of which 401(k) financing option you’re exploring. It’s that if your business fails, you could lose both your company and a massive part of your nest egg. Is it really worth the risk?
Although many recommend trying every other avenue possible before considering tapping into their retirement — starting out with a 0-percent APR business credit card, for instance, to build business credit and time in business — leveraging a 401(k) might still be the best solution for some. Those who are more senior in their life and career, with a more established 401(k), as well as other paid assets and cash in hand, might be a better fit for this solution.
For example, there’s a substantial difference between a 30-year-old with a nominal 401(k) and no owned assets, and a 46-year-old with a house and car that’s paid for, and who also has several retirement and investment funds in play. For the latter person, who is financially more established and can tolerate more risk, a 401(k) loan or ROBS might make more sense.
The best bet is to always research various solutions and consult with your financial advisor and/or tax professional about your specific situation.
Consider both short- and long-term success and failure, as well as what market conditions look like, since that’ll have bearing on your 401(k), too. What are your objectives — both with your business, and personally, too?
What can seem like a low-risk and cost-effective plan in the beginning might have hidden risks and costs, so your best path is always a well-researched one from several vantage points.
The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.