By Bruce Hakutizwi
If you want to start up your own business, or buy a business for sale, figuring out how to finance a business can be the most stressful part. If you’ve decided against a bank loan, or tried unsuccessfully to obtain such a loan, you’ll need to come up with alternative financing.
For many would-be entrepreneurs, tapping into a 401(k) can be an appealing option, particularly if your investment is underperforming and you are launching a business you believe will be a better investment of your money.
When it comes to tapping into 401(k) accounts, the general advice of financial planners has always been, “Don’t do it!” But if you’re considering doing so for the purposes of launching a business, there are some provisions that make accessing 401(k) funds different — and more feasible — than simply drawing out funds for non-business-related pursuits.
The good news is, you may be able to do so if you follow specific steps.
There are three main ways to fund your business using your 401(k):
- Through a Distribution of 401(k) Assets
- Taking a Loan Against the Money
- Through a Rollover for Business Startups (ROBS)
It’s important to remember, however, that none of these options are risk-free, and depending on which you choose, you may still be subject to some form of tax or early withdrawal penalty. Let’s look at each of these options in a bit more depth.
- Distribution of Assets – By taking a distribution on your 401(k) funds before age 59½ you will be subject to 20 percent federal tax and any applicable state tax. You also may be subject to a 10 percent penalty from the Internal Revenue Service, plus whatever fee your policyholder charges for the transaction. This is the simplest — but most costly — option. All that is required for a distribution of assets is to request the paperwork from your 401(k) manager, fill it out and collect the funds with which to buy or start your business.
- Loan – It’s important to note that not all 401(k) plans allow loans. As far as the Internal Revenue Service is concerned however, you can borrow up to $50,000 of your account balance for a loan. Like the distribution option, this only requires filling out paperwork. However, if you choose this option it’s important to consider the monthly financial implications of the payment you’ll be required to make on the loan each month. You are typically allowed more than one 401(k) loan at a time, so it’s advisable to take only the minimum amount needed to minimize interest, and then take a subsequent loan if that becomes necessary. One benefit of this option as compared with a bank loan is that you’ll be paying the bulk of the interest back to yourself as you replenish the funds into your 401(k) plan.
- Rollover for Business Startups (ROBS)- ROBS give you the option of investing funds from your 401(k), or other retirement account, into a new startup business without paying early withdrawal penalties or taxes. When you use a ROBS, your retirement account owns shares of the business, which can be very beneficial if your business becomes profitable because some of those profits can be returned to your retirement account.
To set up a ROB, you will need the help of an attorney and/or CPA. You will first need to establish a C Corporation for your new business. Then you will need to set up a 401(k) plan for the C Corporation and roll the funds over from your personal account into the company account. Those funds are then used to purchase stock in the new company and the proceeds from stock sales is then invested in the business.
Chris George, president and CEO of business brokerage George & Co., said although this is an option he has seen people choose, there are still some tax ramifications that entrepreneurs should be aware of when it comes to ROBS.
“Establishing a C Corporation in itself presents some interesting tax ramifications because in this deferred rollover — and it’s not a tax savings so much as it is a tax deferment — if you were to sell the business that you acquired through a self-directed 401(k), you would then be facing some significant tax issues,” George explained. “A C Corporation is taxed on two levels — it’s taxed on the corporate level and then any distributions that are made to the shareholders are also taxed.”
This, in part, is why many CPAs often recommend businesses be established as S Corporations or limited liability companies (LLCs).
“You don’t see a lot of C Corps being formed unless if for a specific reason.” George said. “That (potential tax liability upon selling) is the biggest downside is a rollover to access 401(k) funds to start a business. But the great thing is that there are many tools available now through the Small Business Administration now that can also help facilitate a rollover.”
Assessing the Risks
While all of these three options can help you when it comes to getting your hands on the cash to buy the business of your dreams, borrowing money from your nest egg never comes without risk. You must be willing to take the risk that if your business endeavor fails, not only have you lost the business itself, but most likely a large chunk of your retirement funds. Obviously in the worst-case scenario the distribution option comes with the greatest risk because you take the chance of losing the money altogether as compared to the loan option where you may still be able to repay your 401(k) loan by securing a new job or other method of income to satisfy that loan.
While there are these risks, there are also many positives to owning a business of your own that are more appealing option than ever. Regardless of which option you choose on your path to business ownership, it’s imperative to get the proper financial, tax, and legal guidance before pulling the trigger.
Bruce Hakutizwi is the U.S. and International Business Manager for us.businessesforsale.com. Bruce is passionate about helping businesses succeed and regularly writes about entrepreneurship and business growth. Connect @BizForSaleUS.