Raising enough money to start a new business is always a difficult feat, especially as banks continue to tighten lending standards. You might need to get creative when looking for funding sources. Enter, your retirement plan.
There are a few different ways you can use your retirement fund to finance your new company, and each one comes with its own pros and cons. Read on to find out if these approaches might work for you and your entrepreneurial pursuits.
401(k) loan
Using a work-sponsored retirement plan, like a 401(k) or 403b, for a loan is an approach that might work for you if you plan to run a business part-time, while keeping your current job. Note that not all work-sponsored plans allow loans – it depends on how your employer set up the plan.
If your plan does allow loans, you are usually able to borrow up to 50% of your account balance, up to a maximum of $50,000. The IRS does not charge taxes (or the 10% early withdrawal penalty) on money taken out for a loan, even if you are younger than 59 ½. There are also no spending restrictions, so you can have full discretion on how to use the money to fund your business.
But there is a downside. You are required to repay the entire loan within 5 years, with interest. In addition, if you leave your job before the five-year mark – say, to run your business full-time – your employer may ask that you repay the entire loan at that time. If you fail to repay the loan, the money will count as a withdrawal, meaning you will owe income tax on the full loan amount, plus a 10% early withdrawal penalty.
Self-directed IRA
Another way to fund your business is through a self-directed IRA. This type of account allows you to invest in “closely-held” businesses, including ones you own.
In order to use this approach, you must first set up your new business so that investors are able buy shares. A C-Corp or LLC structure will work for this. You can then roll over your old IRA or 401(k) balance into the self-directed IRA (if you don’t already have one), and use that money to buy shares of your new business. The business entity will receive the cash to fund operations, while your shares of the business will be held in the self-directed IRA. You will not owe any taxes on the transfer of funds. When the business starts distributing profits to shareholders, your share of the profits will go directly into your self-directed IRA.
The downside of this approach is that there will be restrictions on how you can run the business. For example, you cannot own more than 50% of the business yourself and you cannot personally guarantee any loans for the business. To avoid prohibited transactions, the self-directed IRA approach is best for situations in which you are not taking an active role in running the business, for example, when investing in your friend’s company, or a company run by a hired managed.
Early withdrawal
Another option for new business financing is the early withdrawal. This is a costly approach – especially if you are younger than 59 ½, and thus subject to the early withdrawal penalty – but can still work for some. (While there are some situations that allow you to avoid the early withdrawal penalty, starting a new business is not one of them).
If you just need a small amount of money and do not want to go through the trouble of the other funding methods listed above, then an early withdrawal might work for you. Also, note that withdrawals from a Roth IRA are less problematic than other accounts because you will not have to pay taxes or a penalty. But keep in mind that your investment earnings in the Roth IRA will still get hit by a tax and penalty.
