Do you want to start a business but don’t have the funds or investors biting on your brilliant idea? If that’s the case, you may want to look at borrowing money from your 401(k) fund. This can prove a viable option as long as you understand the risks and have a strong repayment plan in place.
Consider tapping into your 401(k) for starting a business if:
- You cannot qualify for a business loan due to credit issues or time constraints.
- You intend to stay at your job while starting your business.
- You have a solid repayment plan.
- Your business requires less than $50,000. According to IRS rules, the maximum amount you can take from your 401(k) plan is 50% of your vested account balance or $50,000, whichever is less.
- Your retirement plan qualifies, and the administrator of the plan must allow it. It cannot be a Roth 401(k), for example.
Pros and cons of using your 401(k) to start a business
Setting yourself up with rollover for business startups is complicated and includes future risks. So, before you use your 401(k) to start your business, weigh these pros and cons:
Pros:
- You can use your 401(k) to fund a business without paying taxes (more on this below, in the “Robs” section)
- You can start a business without debt.
- You will have immediate equity that you can sell or borrow.
Cons:
- You may be liable for taxes and penalties if the rollover is not completed.
- You will be subject to legal, accounting and administrative fees.
- There will be future risks. If the business fails, you could lose your entire investment.
How to finance your business with a 401(k)
“The unfortunate reality is that most business owners will initially have to fund their businesses from their own pockets,” says Mike Sims, owner of ThinkLions, who funded his business from his 401(k) account. He adds, “For most working individuals, their 401(k) may be the single largest asset that they have and their only option for funding the launch of their business.”
Fortunately, aspiring business owners can use an arrangement called rollovers as business startups to fund their business using their 401(k), without being assessed taxes or penalties.
In the term ROBS, “rollover” refers to the process of moving retirement funds from one 401(k) account to the new company’s 401(k) account, and then from the company’s 401(k) account to the company’s checking account.
Here are the steps to complete a ROBS:
Step 1: Form a C Corporation
– If your business is already registered as an LLC or other entity, you will need to reorganize.
Step 2: Create a retirement plan for your new business
– Choose the right retirement plan, depending on the number of employees and how you will compensate them.
Step 3: Transfer funds to your account
– Rollover funds from your old retirement plan to the new one. The plan administrator will be able to assist you in this process.
Step 4: Issue stock (ownership shares) in the new entity
– Use your retirement funds to buy stock in the corporation.
Step 5: Invest in your company
– Use the funds to invest in your business as per your industry rules.
Note: Whether you put the entire rollover into the hands of a financial services provider or do it yourself, you should consult a professional who can advise you based on your individual situation. A financial services provider that administers ROBS can help you stay on top of regulations and facilitate the process.
Tips to consider before using retirement funds to open a business
Here are a few key strategies to open a business using a 401(k) loan:
- Determine in advance when you expect to make a profit or make up for the borrowed money from the 401(k) fund.
- Start lean to keep your expenses low.
- Ensure you have found your niche.
- Consider the best-case and worst-case scenarios. Evaluate how each will affect your overall finances.
- Have a backup plan.
