Using 401k to buy a business can help you leverage your retirement funds to generate more income.
But should you?
We take a look at the many ways to use a 401k to buy a business. We also help you understand the pros and cons and business financing alternatives you can tap into as an aspiring entrepreneur.
How Using Your 401k to Buy a Business Works
Can you use your 401k for existing business financing or a business startup?
Absolutely.
There are three ways that you can use your 401k plan funds.
These include borrowing against your 401k, a 401k rollover, and taking a distribution.
We’ll cover these in further detail below.
Before you turn to your 401k for business financing, consider:
- How It Might Impact Your Retirement Plan: Can you leverage your retirement account for business financing comfortably? Or, will you end up relying on retirement savings and overextending yourself for your new business?
- How Much You Have (and If It’s Enough): Understanding how much your business start up plan will cost ahead of time is crucial. Figure out how much business financing you can receive from your 401k retirement plan and if it’s enough for a new business.
- Existing Business or New Small Business?: Do you want to use your 401k fund money for a new business? Or, do you want to purchase a franchise? Both come with their own unique advantages and disadvantages.
Planning things out before you buy a new business with your 401k plan will reduce the likelihood of experiencing unforeseen obstacles that commonly jeopardize entrepreneurs and retirees.
Borrowing Against Your 401k
The first strategy you can use if you want to use your 401k fund for business financing is borrowing against it.
Now, it’s important to note that borrowing against a 401k comes with several restrictions. If you’re interested in this type of business loan, here’s what you should know about a 401k loan upfront.
- You can’t borrow against all of your assets and get a ton of cash. You can either borrow against up to 50% of your vested account balance or $50,000, whichever is less. This is substantially less than what you might receive with other loan options.
- Loans that exceed this amount or don’t follow the traditional payment schedule (around 5 years for full repayment with quarterly loan payments) can be considered distributions. These can be subject to additional taxes (unless you’re exempt).
- Take care to see what your options are. Not all 401(k) financing terms are the same across all lenders. Shopping around will give you the best possible loan terms for your business needs.
Borrowing against your loan isn’t a traditional way to get cash. However, it is an option. Like any other loan, research 401k financing extensively. Weigh a 401k loan against the other options here to make sure it’s the right fit.
Rollover
Rollovers tend to be the option that retirees opt for most. Aptly named, rollovers occur when you roll over your existing 401k funds into a new retirement plan.
These plans include the ROBS plan and the BORSA plan.
Put simply, a ROBS transaction works like this: you form a corporation, roll over your funds into a new retirement plan managed by that corporation, and use those funds to finance your business.
As with the above, there are some restrictions that will dictate your rollover experience. These include the following:
- You could potentially be restricted from using this method if your previous employer doesn’t allow it.
- The only business that qualifies for ROBS or BORSA rollovers are C Corps. That’s not inherently good or bad. However, you won’t be able to use any other business structure and fund it with a 401k using this method.
- You must have at least $50,000 in your retirement account in order to use this method. If you have fewer assets, you’ll need to use another financing option.
Opinions on rollovers will vary greatly. Some sources state that C Corp concerns are overblown. You can leverage the single flat corporate tax rate, flexible fiscal years, and a wide range of deductions to save money. A C Corporation won’t be inherently expensive to operate.
Other sources cite major concerns.
The Internal Revenue Service found that many retirees who used ROBS filed taxes incorrectly and ended up with failing businesses. Not every business owner experiences success.
Take your time to research this method and work with legal and financial professionals to ensure the best possible outcome.
Taking a Distribution
The final option you have is taking a distribution.
Distributions are mandatory, but only when you reach 72. You can start taking withdrawals penalty-free once you reach the age of 59 1/2. Avoiding penalties will help you maximize savings and available funds.
Do you want to start a small business and access financing before this age? If so, there are going to be penalties for withdrawing early. Plus, you’ll have to pay income tax on your funds. This isn’t ideal, and it will jeopardize your retirement plan.
It’s important to note that what your 401k allows for will determine how you receive distributions.
This might include getting your distributions in regular installments, in a lump sum, or as requested. Most will offer all these options. Others may restrict how you can access your retirement assets.
Traditional 401ks are subject to income tax. A taxable distribution from your retirement account can affect how much funding will be available to you.
Because you’re interested in starting or buying a business, chances are that a lump sum is going to work best for you. However, you should consult with an advisor to understand the intricacies of distributions and make sure you’re on track to reach your goals.
Should You Use Your 401k to Buy a Business?
As you can see, there are many ways to use your 401k to buy a business. Instead of asking whether you can use your 401k to buy a business, you should ask whether it’s a good idea.
Here are some of the pros and cons of using a 401k to buy a business.
Pros
- Reduced Financing Demands: Leveraging your 401k reduces the amount you need to borrow. This can be a major benefit for those who don’t want to take on too much debt to start their business venture or buy an existing business.
- The Potential for Returns: If you want to generate more income in your retirement or generate more income before retirement, using your 401k to buy a business can be a great way to take your investment and turn it into more cash.
- 401k-Specific Financing Options: It’s easy to use ROBS or BORSA to use your full 401k for business-specific purposes. If a 401k wasn’t meant to be used to start a small business, why would there be a specific solution for it?
Cons
- There’s Always Risk With Business Investment Options: As found by the IRS, many who used ROBS failed in their business endeavors. Your business is not a guaranteed success. You could lose all of your retirement fund.
- Less Cash for Retirement: Using your 401k if you can’t afford to lose it is not advised. It gives you less money for retirement. This could have a massive impact on your lifestyle and your quality of life. You don’t want to live on just personal savings.
- Restrictions and Taxes: Using your 401k does mean you’re subject to taxes and certain restrictions. It may not offer you the degree of freedom and flexibility you’re looking for when buying or starting a business.
Alternatives to Using Your 401k
Your 401k is just one solution for business funding. If the options above don’t appeal to you or your 401k is not a resource you’re willing to leverage, consider these other options.
- SBA Loans: Small Business Administration loans are an invaluable resource. While you’re subject to stringent rules and qualification requirements, you get low interest rates and longer repayment periods. You can then use your business loan to buy a business.
- Seller Financing: Some sellers are willing to help you out. They may help you secure an SBA loan or even offer to give you a loan directly with a small down payment. This can make it substantially easier to fund your business.
- HELOC: A HELOC is a revolving line of credit that lets you borrow against the equity of your home. HELOCs can be sizable, based on home equity minus any remaining mortgage balance. This also bolsters your cash flow for continued business expenses.
- Investors: Do you know anyone who might be willing to invest in your business venture? Reaching out to friends, family, and investors could help you get financing for your new business as well. Look for creative ways to get cash into your bank account.
Access More Business Acquisition Financing Options from Credit Suite
Credit Suite is dedicated to your new business’s success. From our Fundability Program to alternative financing options like our Credit Card Stacking Program, we’re here to help you on your business funding and credit journey.
Discover how Credit Suite can help you make your business dreams a reality with easier access to funding, step-by-step credit-building support, and more today!
