Should I Finance My Business With My 401(k)? 3 Good Options

We don’t have to tell you that financing your business is one of the biggest challenges of entrepreneurship, whether you’re just starting out or looking to grow an existing company. Business loans work for many, but you might not like the idea of taking on debt, especially if you have funds of your own that you can bring to the business. The problem is that most people have personal savings tied up in investments or retirement accounts.

Fortunately, there are ways to take cash out of a retirement account and invest the money in your business. Ordinarily, if you withdraw money out of a 401(k) or Individual Retirement Account (IRA) before the age of 59 ½, you have to pay income taxes on the money plus a 10% early withdrawal penalty.

Short of simply withdrawing money from your retirement account, there are two better options that allow you to tap into retirement funds without having to pay income taxes or penalties: 1) taking out a 401(k) loan; or 2) rolling over your balance into a new 401(k) plan, called a Rollover as Business Startup (ROBS). Both of these options come with their own pros and cons, but the cons can be pretty significant. In both cases, there’s the inherent risk of losing your retirement nest egg if your business doesn’t do well. So, if you’re looking for a simple answer to the question, “Should I finance my business with my 401(k)?”—the answer depends on your personal level of risk tolerance.

If you believe the risk is worth taking, the money in your retirement account could be the ticket to starting or growing your business. But before you drain your savings, you should learn as much as possible about what’s at stake. Here’s an in-depth look at the two options for IRA or 401(k) business funding, plus alternatives if you’re still on the fence about whether to use a business loan or retirement funds.

Option 1: Use a Retirement Plan Loan to Finance Your Business

Best for: Business owners who need less than $50,000 in financing and plan to remain employed while they are exploring business opportunities.

If your 401(k) or other eligible retirement plan allows loans, the IRS permits you to borrow up to half of your vested balance, or $50,000, whichever is less. You can use the loan for any eligible purpose, including business purposes. Interest is charged on the loan, but since you’re borrowing from yourself, you’re actually paying the principal and interest back to yourself.

The key is that you have to remain employed and enrolled in the employer-sponsored retirement plan while the loan is outstanding. If you lose your job or decide to leave, you have to pay back the full loan within two months. So for most entrepreneurs, a 401(k) loan isn’t practical unless they’re exploring a business as a side gig for a while. Most people use 401(k) loans not for business but for personal expenses, such as medical costs or home renovation costs.

Who’s Eligible?

Only some retirement plans allow you to take loans, including profit sharing plans and 401(k), 403(b), and 457(b) plans. You can’t take a loan from an IRA (except for something called a 60-day rollover, which functions like a very short-term loan).

Be sure to check with your plan administrator; some plans don’t allow loans, and others restrict what borrowed funds can be used for. For example, your employer might specifically prohibit funds from being used to start a competing business.

How Much Can You Borrow?

The IRS has rules around how much money someone can borrow form their retirement plan in any given year. You can borrow the lesser amount of:

• $50,000; or
• Half of your vested balance.

Let’s say you have $80,000 in your 401(k) account. The maximum you can borrow in a calendar year is half of that balance—$40,000. Let’s say you borrow $10,000 from your 401(k) in January of the calendar year. After that, you find that you need more money in July. In July, you can borrow a maximum of $30,000.

What Are the Cost and Terms of the Loan?

In most cases, the interest rate on a retirement plan loan is 1% plus the prime rate. And the time to pay back the loan is usually 5 years, on par with a medium-term loan. There might also be modest issuance or administration fees, but these go to the provider (not back into your own account). The specific details of your loan will vary based on your plan administrator’s rules.

The largest “cost” of a 401(k) loan is the lost opportunity from borrowing the funds, instead of keeping them in your retirement account. For instance, say the average return on your retirement account is 10%. But the interest rate on your plan loan (that you’re paying yourself) is 6%. That’s a difference of 4% which can add up to thousands of dollars over time. Now, if you believe that your business profits will counteract that loss, then the loan might be worthwhile.

There’s another important catch: If you’re using an employer-sponsored retirement plan and lose your job (or decide to leave voluntarily), the entire balance plus interest is due within 60 days. That’s a very short period of time, and if you can’t pay back the money, the loan goes into default.

What If You Can’t Pay Back the Loan?

In an ideal world, you would borrow money from your retirement plan, see your business grow, and comfortably be able to pay back the money with interest within the five-year deadline. But things don’t always work out as planned. Your company’s cash flow might not be as strong as you hoped, or personal financial emergencies might come up.

If you miss multiple installment payments or are unable to pay back the loan within the time frame set out in your plan documents, the loan goes into default. That means the IRS will treat the money you took out as a withdrawal. If you’re under 59 ½ years of age, you’ll have to pay income taxes on the money plus a 10% early withdrawal penalty.

There’s one piece of good news: Even if you default on the loan, the plan administrator can’t report this to the credit bureaus. This is not a like a defaulted mortgage or student loan which will impact your credit score. Your default shouldn’t hurt your ability to get financing down the line.

Pros and Cons of Retirement Plan Loans

As you’ve seen by now, there are multiple advantages and disadvantages to taking a retirement plan loan. Here’s what to consider as you’re thinking through this option:

Pros

• You avoid paying taxes and penalties on the money you use for your business—as long as you pay back the loan.
• 401(k) loans typically have lower interest rates and are easier to qualify for than many other types of business loans. No credit check required.
• You’re paying yourself back vs. being indebted to a third party.
• If you default on the loan, your credit score won’t take a hit.

Cons

• The interest rate of a 401(k) loan isn’t the only factor to consider. You might also need to pay issuance and administration fees.
• You must factor in the lost investment earnings you could have made if you hadn’t taken the loan.
• Should you lose your job or quit while the loan is outstanding, the entire balance is due in 60 days.
• If you default on the loan, you’ll be responsible for paying income taxes plus a 10 percent penalty on the entire balance (if you’re under 59½).
• If your business doesn’t do well, you could lose a portion of your retirement savings.

Jeff Hensel, owner of private mortgage lender North Coast Financial, used a 401(k) loan to start his company:

I took out a 401k loan and will definitely use this option again in the future if I have to. The best part is that the interest paid on the 401k loan is paid to yourself (the money goes back into your 401k account). If $50,000 or less is needed, this is an excellent option for borrowing funds. I found 401k loans to be much more cost effective than credit cards, private money loans, or lines of credit. The only downside was the $50,000 loan limitation.

If you’re interested in funding your business with a 401(k) loan, you can get started by contacting your plan administrator. The timeline for a retirement plan loan ranges from one day to several weeks, depending on the application process outlined in your plan documents.

Option 2: Use ROBS to Finance Your Business

Best for: Business owners who need $50,000 or more in financing and want to devote themselves full time to the business.

Rollovers as Business Startups (ROBS) is another way to access retirement funds from a 401(k), IRA, or other eligible retirement account without having to pay income taxes and early withdrawal penalties.

A ROBS offers more flexibility than a 401(k) loan because there’s no obligation that you have to remain employed. In fact, you cannot use a retirement account from a current employer. However, doing a ROBS is more complicated than taking a loan from your retirement plan.

First, you have to structure your business as a C-corporation. Then, you have to set up a new retirement plan under the C-corp. At that point, you roll over the funds from your existing retirement plan into the new company’s retirement plan. Finally, your new corporation sells stock to the retirement plan, and the company uses the proceeds from the sale as a source of capital. (One catch: You can’t pay owners’ salaries from these funds.)

Who’s Eligible?

There are four main eligibility requirements for a ROBS:

• You need an eligible retirement account—such as a 401(k), 403(b), SEP, Keogh, or traditional IRA. Roth accounts are not eligible.
• The retirement account must have at least $50,000.
• The business owner should be an employee of the business and receive a salary.
• You must either have a C-corp or be willing to structure your business as a C-corp.

If you meet these requirements, you can get started with a ROBS. Although you can set up a ROBS on your own, there are a lot of IRS regulations and legal rules, so we recommend hiring a professional like Guidant or Benetrends.

What’s the Cost of ROBS?

ROBS providers charge a one-time, upfront fee and an ongoing administration fee. The one-time fee, which comes to around $5,000, covers C-corp and retirement plan setup and issuing the stock certificates. The ongoing administration fee, which is approximately $100 to $150 per month, ensures that you’re in compliance with any rules around retirement plan administration.

How Much Money Can You Use?

You’ll notice that one major difference between a 401(k) loan and ROBS is the amount of money you can use. With a 401(k) loan, $50,000 is the maximum you can borrow. With a ROBS, $50,000 is the minimum you have to take out of your retirement account. In large part, your choice between these options will depend on the amount of money that you have in your retirement account and the percentage that you’re willing to put towards your business.

ROBS vs. Retirement Plan Loans

The biggest difference between a retirement plan loan and a ROBS is that a ROBS isn’t a loan. When you use a ROBS, you won’t have any debt to pay back—not to yourself and not to a third party. That can be very appealing to business owners who don’t want any of their business’s cash flow going to loans.

However, as with 401(k) loans, there’s the risk of losing retirement funds. If you roll over money into your business and the business doesn’t do well, you could lose your nest egg. Since there’s no ceiling on the amount of money you can use with ROBS, that actually creates greater risk. If your business doesn’t do well, you could lose all of your retirement savings, not just a subset.

Plus, there are other disadvantages that are unique to ROBS. Setting up a C-corp and a new retirement plan isn’t simple, and you need to comply with a lot of legal rules to avoid hefty tax penalties. There’s also a slightly elevated risk of the IRS auditing your business when you do a ROBS.

Pros and Cons of ROBS

As with retirement plan loans, there are multiple advantages and disadvantages to a ROBS. Here are the pros and cons of ROBS:

Pros

• You avoid paying taxes and penalties on the money you use for your business.
• You don’t have any debt to pay back, so your business could grow faster.
• You have more control over your retirement funds, since you’re investing them in your own business.
• No credit checks.

Cons

• There’s a slightly higher chance that the IRS will audit your business.
• If your business doesn’t do well, you could lose all of your retirement savings.
• You have to administer a new retirement plan, including educating employees about the plan and allowing them to participate.

Suzie and Todd Ford, co-owners of NoDa Brewing Company, used a ROBS to start their business:

We rolled our 401(k) plan into our company’s 401(k) plan that was created through the ROBS process. The full process took a couple months. Guidant directed us and made things easy along the way. A friend of ours is a CPA, and she’s actually the one who recommended it.  One of her clients used it to start his business, and was pleased. We have a monthly maintenance fee which includes unlimited monthly calls, questions, and inquiries from me, plus annual reporting. We recommend using ROBS as long as you positively understand the risks and that if your business fails, you more than likely will lose all your 401(k) funds.

The big “con” of either 401(k) financing option is that if your business fails, you could lose both your company and part—or all—of your nest egg. Is that really worth the risk? We recommend learning about other types of business loans so you can understand all of your business financing options and make an informed choice.

Option 3: Take a Distribution from Your Retirement Account

There’s one last option for entrepreneurs who want to tap into their retirement savings to start or grow a business: You can take a cash distribution from your retirement account. However, unless you’re under the age of 59 ½, you will have to pay income taxes on the distribution and a 10% early withdrawal penalty.

For this reason, we don’t recommend this option for entrepreneurs unless you’ve exhausted all of your other financing options. Using a 401(k) loan or ROBS lets you avoid the income tax and penalties.

→TL;DR (Too Long; Didn’t Read): Using a 401(k) loan or ROBS allows you to tap into retirement funds without paying income taxes or an early withdrawal penalty. A 401(k) is better for entrepreneurs who are planning to keep their current job while exploring business opportunities. ROBS is better for larger financing needs and for entrepreneurs who want to work full-time on their business.

Top Alternatives to 401(k) Business Funding

Now that you know the details about 401(k) and IRA business funding, you can see that each of the options has a certain degree of risk. We suggest that you sift through all of your other business funding options before you decide to dip into your 401(k) to finance your business.

You might be wondering which financing options are your best alternatives to financing your business with your 401(k), and the answer to this question will be different for every business owner. That said, there are two business financing sources that will generally be a business owner’s best bets when it comes to finding a less risky source of funding than their 401(k).

Business Loans

You might be thinking about funding your business with your retirement savings because you have bad credit or are concerned that you won’t be able to qualify for a business loan. Or maybe you walked into your local bank, and they denied your loan application. That doesn’t mean you can’t qualify for a business loan.

Even if your business is just starting out or if  your personal credit is less-than-stellar, there’s likely still a business loan option that you can qualify for. From secured financing options—like invoice financing and equipment financing—to short-term options—like a short-term online loan or a business line of credit—business loans come in all different shapes and sizes, some of which are surprisingly accessible to business owners. There are business loans for startups and people with low credit scores.

At the end of the day, a business loan might be more palatable than dipping into your 401(k) if you consider all of your options.

0% Intro APR Business Credit Cards

Many people who consider using their retirement plans to fund their business need just a small amount of money. In fact, the average 401(k) loan is just around $10,000. If your funding needs aren’t too high, business credit cards might be an easier and more cost effective solution for you. Cards rely on personal credit, so the higher your credit is, the better the card you’ll be able to qualify for. But there are credit cards for different score ranges.

Business credit cards can be beneficial for both new and established businesses. Many cards offer a 0% intro APR period. This feature is exactly what it sounds like—for several months after account opening, you don’t have to pay any interest on expenses. As long as you make your monthly minimum payment on time every month, you’ll be able to carry an interest-free balance from month-to-month during a 0% intro APR period. Essentially, your business credit card works like a free loan during the zero-interest period.

If you think a 0% intro APR card might be a good alternative to 401(k) business funding for your business, then we suggest you look into the American Express Blue Business Plus. With a 15-month 0% intro APR period, this business credit card offers the longest no-interest intro period available on the market. Plus, as you spend, you’ll earn rewards points at 2x for the first $50,000 you spend every year. After 15 months, a variable APR sets in at a rate depending on your creditworthiness and the market Prime Rate.

→TL;DR: Business loans and business credit cards are less risky alternatives to 401(k) financing for a business. Borrowers from many different credit profiles can access business loans and credit cards. There are also options for startups.

401(k) Business Funding Requires a High Risk Tolerance

The short answer to “Should I finance my business with my 401(k)?” is that it depends on your risk tolerance. Here’s what to think through when deciding whether to funnel retirement funds into your company:

• 401(k) loans allow you to take a loan from your own retirement account. You pay yourself back the principal and interest, typically over a five-year period.
• ROBS is a more complicated option for larger financing needs. You create a C-corp and a new retirement plan and roll funds over from your old retirement plan into your new one.
• Outside of a loan or ROBS, we don’t taking an early distribution from your retirement account. You’ll end up having to pay income taxes and an early withdrawal penalty.
• Consider all your options before using retirement funds for your business. Business loans and business credit cards work for many entrepreneurs.

If you have a really strong business plan and think that your business could grow quickly, then using retirement funds could be worth the risk. But you should always have a Plan B in case things don’t work out as you would have expected. Planning ahead is the best way to succeed as a business owner.

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from Fundera Ledger https://www.fundera.com/blog/finance-business-401k