There are plenty of ways aspiring entrepreneurs can secure enough working capital to start a business. While there’s likely more than one loan type that fits your needs, there are other business financing methods that won’t work for you, long-term. It’s possible that using a 401(k) to start a business fits into this category.

In the next few sections, we’ll explore the 3 main options entrepreneurs have when it comes to using retirement accounts to finance a business, how each works and who they’re right for, as well as the definition of a ROBS 401(k) and all the tax implications of withdrawing early.

3 Options for Using a 401k to Start a Business

When you’re looking to use a 401(k) to finance your business, there are three paths available:

ROBS 401(k)

A Traditional 401(k)

Retirement Account Distribution

The reason a ROBS 401(k), which stands for Rollovers as Business Startups, is considered the best option of the three is because it’s the only option that doesn’t accrue taxes, penalties or additional interest charges.

The ROBS method allows you to use either your 401(k) or your IRA to fund an acquisition or a startup without any instantaneous tax burden or penalties.

Which Accounts Are Eligible?

There are only a few retirement plans that allow you to borrow against for business purposes. Included in this list are 401(k), 403(b) and 457(b) plans, as well as profit sharing plans. IRAs prevent you from withdrawing funds for business purposes unless you will be able to repay within 60 days, which we’ll learn more about later.

If you have questions about your retirement plan’s rules, be sure to speak to your account administrator. Some plans don’t allow you to borrow against them and others are restrictive in how withdrawn funds can be used, asking your administrator will give you immediate clarity.

To gain a greater understanding of ROBS and the other two 401(k) financing options, let’s break them down accordingly.

Using a ROBS 401(k)

With a ROBS 401(k), assets from qualified retirement accounts, like a 401(k) or a traditional IRA (individual retirement account), are rolled over and invested in a new business or franchise, or used to buy or put money into an existing business with the help of an attorney or a ROBS provider. Rolling over the funds preserves the tax-deferred status of the account without being subjected to early withdraw penalties, just like it would be for a 401(k) and IRA.

How It Works

Under most circumstances, taking money out of a retirement account before age 59 and a half triggers the account holder to pay income tax for the money withdrawn, plus a 10-percent penalty. The difference with a ROBS, however, is that the funds rollover directly in your business as an investment. Therefore the funds aren’t counted as a withdrawal from your retirement account or a loan against it. Even with this investment stipulation, borrowing against a 401(k) to finance a business still requires repayment with interest, as well as employer approval in many cases.

To ensure this process goes smoothly, ROBS 401(k)s normally follow the same procedure:

  • A business is formed as a C-corporation, as it permits shareholders to invest in the organization. Once the C-corp is established, a new 401(k) plan is set up for the company.
  • The owner is then able to roll existing retirement accounts — most retirement accounts are eligible — into the new 401(k) plan.
  • Once rolled-over, any funds in the account can be used to purchase stock in the C-corp which is then used to invest in the business.

Who It’s Right for

If you have more than $50,000 in a 401(k) or Traditional IRA, and plan to work in the business full-time, a ROBS is the best option for 401(k) business financing. In addition to the asset figure required, for a ROBS to be a good financing option, you need to also meet the following qualifications:

Plan to Be an Active Investor

To qualify for a ROBS, you must be fully devoted to the business you’re investing in. ROBS can’t be used for side-investments or by partners who don’t intend to be active in the business.

Investors with Significant Retirement Assets

One of the advantages of a ROBS is that you can finance your business without taking out a loan or accumulating business debt. While it doesn’t carry any early withdraw fees, it’s recommended that your accounts have more than enough funds to support both the business investment and retirement needs.

Find the Right Provider

Using an experienced ROBS partner that has set up many rollovers can help to expedite and simplify the process. It should also be noted that ROBS administrators can charge $5,000 or more, on average, with monthly administration fees of more than $125. While this monthly fee covers any assistance with tax filing for your ROBS, it’s still important to note.

Using a Traditional 401(k)

A ROBS 401(k) is the best option if you need a significant amount of funding to start your business. However, if you’re planning to keep your current job or won’t be an active member of the business, using a traditional 401(k) to buy a business is the better entrepreneurial (or investment) option.

How It Works

Businesses are able to make their own rules when it comes to retirement plans. Because of this, employers occasionally limit withdraws to your own personal contributions, while others place no restrictions against what can be taken out as a loan.

Regardless of the amount in your 401(k), the IRS restricts account holders from withdrawing more than $50,000 or half of your vested balance in your plan—whichever is the lesser amount.

Repaying the withdraw is ultimately comparable to a traditional business loan, with interest around 8 percent and a maximum term of five years. While 8 percent is the most common interest rate, each rate is set by the administrator. Each of your payments goes directly back into your plan.

Who It’s Right for

If you’re not eligible to use a ROBS 401K, you’re still able to borrow against your 401(k) or IRA if you fit into one of the following categories:

  • Need less than $50,000 in funding
  • You’re staying with your employer
  • You won’t be a full-time employee of your startup
  • This is a passive income business
  • You can repay within 60 days

If you’re withdrawing from an IRA, it’s in your best interest to repay anything you take within 60 days to safeguard yourself from penalties and taxes. Repaying within 60 days doesn’t fully guarantee that you won’t be subjected to any fees, but this approach offers the most protection.

The same rules apply for a 401(k). Once you’ve separated from your employer or your 401(k) funds are moved into a non-exempt account, you will have 60 days to repay the loan.

While neither traditional or Roth IRA’s allow account holders to withdraw funds, like a 401(k) plan would permit, they do approve penalty-free distributions depending on the situation. These circumstances include education expenses, medical expenses not reimbursed by your insurance provider that exceed 7 and a half percent of your adjusted gross income or health insurance premiums if you’re unemployed.

The penalty is also removed if you’re taking the distribution in equal periodic payments over the period of your life expectancy or due to an IRS levy of the qualified plan.

It’s important to note that, at this time, no penalty-free distribution for starting or buying a small business exists.

As we learned with a Traditional 401(k), money from an IRA account can be taken for less than 60 days without facing major fees once within a 12-month period. If you’re unable to pay the money back within the 60-day window, the funds will be viewed as if you had cashed it out by the IRS; cashed out distributions are taxed at the 10-percent gross income tax penalty rate.

Using a Retirement Account Distribution

Also known as cashing out, retirement account distribution is the act of taking a distribution from a retirement account to start or invest in a business.

Any non-qualifying distributions for holders under 59 and a half become taxable income and assess a 10-percent penalty. However, there are qualifying distributions, including things such as pursuing advanced education or purchasing your first home.

How It Works

After you’ve concluded that you’d like to cash out your 401(k) to fund a business, the first step you will need to take is to request paperwork from your retirement account company. Depending on the provider, this can be accomplished over the phone or online. It’s likely that the company that established your retirement account will also need to approve the request.

Due to the complexity of the stipulations of withdrawing funds from a retirement account before you’ve reached retirement age, delays should be expected.  In addition, actually receiving your funds can be a complicated process, as certain plans and companies confine disbursements to either once a quarter or even once a year.

If this is the route you plan to take, it’s paramount that you plan ahead of time to verify when you’ll have the funds and understand how your account provider disburses funds. Once the money has hit your account, it will have to be declared as taxable income, minus any fees.

Who It’s Right for

Typically, withdrawing funds from your 401(k) or IRA to start or fund a business is used as a last resort. Financial planners advise that while it’s certainly an option to fund a business, it’s almost always the most expensive option. In addition, early withdraw means your funds could lose potential earnings because of their tax-advantaged retirement account status.

Two exceptions to the rule do apply. Withdrawing funds from a retirement account is a viable option if you’ve held a Roth IRA for more than 5 years and have made significant contributions, or if you’re already at least 59 and a half years old.

Using a 401(k) to Start a Business: The Verdict

As we’ve learned, using retirement funds to start a business is possible, but it’s not ideal. Unless you’re 59 and a half years of age or older, you’ll essentially waive your rights to additional interest on your own money. However, if you’re using a 401(k) to start a business to call your own after retirement, it could certainly be a wise investment.

Before withdrawing anything from a retirement account, we recommend that you exhaust every business financing option available to your organization. We also suggest that you do what you can to improve your business credit.

If, after exploring these avenues, you’re still left without the funds necessary to establish your business, you’re more than able to use your 401(k). Ultimately, this is your decision, regardless of what financial experts suggest. If you believe building your dream through 401(k) business financing is the best option for you, more power to you.

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