(Below, is a guest post provided by Rick Pendykoski. More about him at the end of the post.)
Thinking of starting or buying a business with your 401k funds due to insufficient startup budget? You may have several questions such as 401k vs IRA – which is better or what are the rules governing the withdrawals from retirement funds for financing a new business.
This article helps you understand how to use your retirement funds for starting or buying a business. Let’s take a look:
1. Choose a Rollover for Business Startups (ROBS)
With a ROBS, you can invest your retirement funds for starting or buying a business tax-free and penalty-free. There is no repayment even if your business fails. It is a great way to use your 401k funds especially if you have more than $50,000 in qualifying retirement savings. In order to use a ROBS you need to:
- Have an eligible retirement account which should be tax-deferred and have over $50,000 to be worth the setup fees.
- Be willing to register your business as a C corporation because the business is selling shares directly to a 401k account.
- Be a legitimate employee of the business for as long as the funds are invested.
2. Borrow from your IRA or 401k
If you intend to borrow from your 401k, you can do so up to $50,000 or half of your vested plan, whichever is less. The loan terms on this retirement plan are usually 5 years with interest paid to your retirement account. You can withdraw funds penalty-free for up to 60 days, given that you fully repay them within that time frame. This is a good option if you need less than $50,000. If you need more, a ROBS is a more economical choice.
When borrowing from 401k:
- Some employers allow you to borrow against both – your contributions and those made by them. On the other hand, some limit the loans to the contributions which you have made into the plan.
- The IRS restricts borrowing from your 401k account to the lesser of either half of your vested balance in the plan or $50,000. The loan term usually spans over a maximum of 5 years and the interest levied is similar to a traditional business loan, which is approximately 8%. The interest payments go back into your plan. In case your employment ceases while you still owe money on your 401k loan, you will still be responsible for repaying the loan. If you are under 59 and half years, you will be charged a 10% early distribution penalty.
When borrowing from a traditional IRA:
- Both traditional and Roth IRAs do not allow penalty-free distributions for starting or buying a small business.
- You are allowed to withdraw funds for up to 60 days without penalty and if you fail to repay the loan within those 60 days, you will have to pay a gross income tax with a 10% penalty. With an IRA account you are allowed to do this one time only within a period of one year.
3. Cash out your IRA or 401k
You cash out your 401k or IRA when you withdraw either a full or partial distribution to start or invest in a business. This should be your last option because if you are under the retirement age of 59 years and a half, any non-qualifying distributions will be taxed along with a 10% penalty. You can also consider this option if you have a Roth IRA with a substantial amount which has been in that plan for more than 5 years.
Also, the rules for cashing out your 401k can be very limiting in nature which can make the process complicated. Hence, you should expect delays as some retirement plans restrict disbursements to once a quarter or once a year. After receiving your funds, you will have to declare them as regular income for your taxes. This is mostly always the most expensive option.
In a nutshell, it depends on your situation whether or not draining your 401(k) or traditional IRA is a good option to start or buy a business. If you currently fall within the lowest tax bracket, using your IRA savings could work for your startup business. Also, borrowing against your retirement account could work if you are capable of repaying those funds within 60 days. A ROBS is a safe solution if at all you are planning to use your 401k funds for starting or buying a business. It allows you to use your retirement funds such to finance or start a business tax-free and without any penalty.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning. Over the last 10 years has turned his focus to self-directed accounts and alternative investments. Rick regularly posts helpful tips and articles on his blog at SD Retirement. You can also find his writing on Business.com, SAP, MoneyForLunch, Biggerpocket, SocialMediaToday, and NuWireInvestor. If you need help and guidance with traditional or alternative investments, email him at email@example.com