401(k) business financing is a franchise funding method that allows an entrepreneur to draw money from their retirement account to start a business. Also known as Rollovers for Business Startups (ROBS), 401(K) gives the owner access to their own money without any tax penalty or withdrawal fee.
There are three ways you can start a business using 401(k) business financing. This funding mechanism allows you to borrow money from your retirement savings. As mentioned, this technique does not cost you any taxes or penalties, making it appropriate to deal with adverse situations.
3 Ways of Using a 401(k)
If you are new to 401(k) financing, you must be aware of the three popular techniques that can help you to avoid immediate tax obligations and penalties. The three ways of using this popular business financing technique are:
Use a ROBS
It is the most effective way of using your 401(k). A ROBS is not about withdrawing your money from your retirement accounts. Rather it is a technique that lets you tap your retirement funds to finance your new business. Here, you can take help from a ROBS provider for easy navigation of such transactions.
However, ROBS is not the way out for everyone. The qualification for taking ROBS as a financing option are:
- If you are planning to keep your business outside employment or invest passively in a business, you won’t be qualified for a ROBS. A person needs to work full-time in business to opt for this technique.
- A ROBS is a good financing option for those who have enough retirement assets. With this technique, you can finance your business without taking any loans. If needed, you can also use a ROBS along with other financing options to reduce your debt.
- You must have an eligible IRA account for a ROBS. Even if you are eligible for both the IRA and traditional 401(k). However, you will not be able to use the IRA for a ROBS. Your retirement account should have at least $50000 as the setup fees and has to be a tax-deferred IRA account.
- Your business needs to be registered as a C-corporation to be eligible for ROBS.
- You must offer a strong retirement plan for your employees to fund your business with ROBS.
Borrowing Against Your IRA
Both traditional and Roth IRAs allow penalty-free distributions, but not for starting a small business. You can withdraw funds from your retirement accounts for 60-days without penalty. However, if you fail to pay the money back within this window, you will be taxed for a distribution from your account. Also, these account types let you borrow money one time within a one-year period.
However, if you have a 401(k), you can borrow up to $50,000 from your retirement account. Here, the loan term is five years, and you need to pay interest to your IRA account. The monthly interest for such loans is 8%. Thus, for newbie entrepreneurs who need more than $50,000, a ROBS is a much more cost-effective option than an IRA borrowing.
Cash Out from 401(k)
Cashing out your 401(k) is an option that you take during a partial or full distribution. If your age is less than the retirement age, all your non-qualifying distributions will be assessed by the IRS with a 10% penalty. According to the IRS, educational or housing fund borrowing is considered a qualifying distribution. However, when it comes to borrowing for a business purpose, it is registered as non-qualifying distribution. Because of this, cashing out your 401(k) should be the last option for funding your business.
However, if you are past the retirement age or have a Roth IRA and have a plan for contributions for five years, cashing out makes sense. With these two exceptions, cashing out a 401(k) can be an acceptable funding option.
Funding from a Roth IRA is taxed in the year the profit is earned. After you hit your retirement age, all the withdrawals are made without any tax obligation. However, here your contribution plan has to be at least five years. However, similar to traditional IRA, cashing out from your Roth account before the retirement age may cost you a 10% penalty on all your earnings.
Why Use 401(k) to Start a Business
A 401(k) is a great alternative to grants, investor funding, and business loans. There are many reasons why entrepreneurs use this technique to fund their businesses. Some of the benefits of using your 401(k) are:
- It gives you control over the capital source.
- You get control over the money quickly.
- You do not have to incur debt from a third-party financer.
- Fund withdrawals can be made without paying income tax.
- The owner will get back all the interest.
- You do not need to go through a credit check.
- It is great for buying a franchise.
Want to utilize your retirement funds to finance your business? If you have enough money in your retirement account, consider using 401(k) financing to start your business.