As a small business owner, you have many options available to help fund your business. However, with traditional business loans you are risking taking on a lot of debt so if you do not feel like taking that risk, you can use your personal savings or retirement accounts like your 401(k) and individual retirement accounts (IRAs). In this article, we will discuss what you need to know about financing your business with a 401(k) and the pros and cons of using them.
Starting a Business with a 401(k)
When you want to use a 401(k) to start your business, you take on a different kind of risk. By withdrawing money out of your 401(k) or IRA before you are 59 ½, you need to pay income taxes on the money plus an early withdrawal penalty of 10%. Fortunately, there are two ways you can withdraw your retirement funds without penalties or paying income taxes. You can take out a 401(k) loan or rollover into a new 401(k) called ROBS which means rollovers as business startups.
What Is a ROBS 401(k)?
A rollover for business startups is used to fund the purchase or growth for a small business. Small business owners must create a C-corporation and create a 401(k) for it. Then, the business owner’s rollover assets they have in other 401(k) accounts into the new one for the business. This is a great financing option because it is the only option that does not have penalties, extra interest charges, or accrues taxes.
With ROBS, you do not have to repay monthly after you roll over a 401(k) and is not considered a withdrawal from your 401(k). You also do not have to repay any of the rollover 401(k) funds even if your business fails.
One of the biggest differences between a ROBS and a 401(k) loan is that with a ROBS the minimum you need to take out of your retirement account is $50,000 and the maximum amount you can borrow is $50,000 with a 401(k) loan.
Should You Use a ROBS?
A ROBS is the best option for 401(k) financing if you have more than $50,000 in a 401(k) or IRA. The following qualifications are required for a ROBS:
- Must be an active investor: ROBS cannot be used for side investments or by people who are not active in the business.
- Have enough funds in your retirement assets: with ROBS you can finance without taking out a loan, so it is recommended you have enough funds in your account.
- Use an experienced ROBS partner: an experienced ROBS provider can help simplify the process. These people charge a lot of money so make sure you take that into account with your budget.
Pros and Cons of ROBS
- You do not have to pay debt back
- You avoid paying taxes and penalties
- You have more control over your retirement funds
- No credit check required
- The IRS will audit your business
- You can lose your retirement savings if your business is not successful
- You need to administer a new retirement plan
Using a 401(k)
If you need less than $50,000 and plan to stay employed, a 401(k) is the right option for you. You are charged interest with this loan but since you are borrowing from your own retirement plan you are paying the principal and interest back to yourself.
Should You Use a 401(k) Loan?
A 401(k) loan is the best option for you if you have the following:
- You need less than $50,000
- You are staying employed
- You will not be a full-time employee of your startup
- You can repay within 60 days
Pros and Cons of 401(k) Loans
- You avoid paying taxes and penalties as long as you pay back the loan
- Low interest rates and easier to qualify for
- You are paying yourself back instead a third party
- Your credit score will not be affected if you default on the loan
- You might pay additional fees like issuance and administration fees
- If you lose your job or quit with the loan outstanding, you will have 60 days to pay the balance
- You will be responsible for paying income taxes and a penalty if you default on the loan (if you are under 59 ½)
- You can lose your retirement savings if your business fails
The Bottom Line
Now that you have a better understanding of how you can use a 401(k) loan for financing your business, it is up to you to decide which one is the best option to either start your up business or continue growing it.