You want to start a business – there’s just one problem. You don’t have the funds. The investors aren’t biting on your brilliant idea. Taking out a small business loan doesn’t sound that good, either. What are you to do?
Using a 401(k) to Start a Business
“The unfortunate reality is that most business owners will initially have to fund their businesses from their own pockets,” says Mike Sims, owner of TH!NKLIONS, who funded his business from his 401(k) account.
“No one believes in your business as much as you do, and most banks or investors won’t be willing to risk their money if you haven’t done the same.”
Few people have enough cash on-hand in their checking or savings account to get started. So they turn to their 401(k)s, where they’ve amassed a chunk of money that can be used as start-up capital. But is that really a good idea?
Pros and Cons of Using a 401(k) to Start a Business
Using a 401(k) to start a business can seem like an attractive idea. After all, it’s probably where you have most of your money.
“For most working individuals, their 401(k) may be the single largest asset that they have, and their only option for funding the launch of their business,” says Sims.
But before you raid your 401(k) to start your business, it’s crucial that you weigh the pros and cons.
You’re taking money out of your retirement account – robbing money from your future self.
Levar Haffoney, a principal at Fayohne Advisors, LLC, offers up these pros and cons of using your 401(k) to start a business:
- You can roll over funds from a 401(k) tax-free.
- You can start or purchase the business without debt.
- You’ll have immediate equity (which you can sell or borrow against).
- The business can fail, which means that you’d lose your entire investment.
- IRS scrutiny – if the rollover is not completed properly, you may be liable for taxes and penalties.
- You’ll be subject to fees.
On one hand, you can have the money to start a business without any debt. On the other hand, it’s a big risk – you’re betting on your future, and could lose everything you’ve saved up to this point.
What to Consider Before Using a 401(k) to Start a Business
If you’re thinking of taking money out of your 401(k) to start a business, ask yourself a few questions:
- When do I expect to turn a profit?
- What will my income and expenses look like?
- When will I be able to make up for the lost money that I borrowed from the 401(k)?
- Do I have a backup plan?
- How will this affect my overall finances?
- What are the financial implications of borrowing from my 401(k)?
Answering these questions can help you carefully consider this option and understand what the consequences will be.
How to Finance Your Business With a 401(k)
Would-be business owners can take advantage of something called ROBS – or rollovers as business start-ups. Through ROBS, you can use your 401(k) to fund a business without paying taxes or penalties.
While that may sound great, setting yourself up with ROBS is complicated. You need to form a C Corporation and then create a new retirement plan under your business. After that, you need to transfer funds to your account. Once you’ve done that, your retirement funds will buy stock in the corporation.
At that point, you can use the funds to invest in your business. On top of that, you typically need the help of an attorney or a CPA to facilitate the process, which can add up.
As you can see, the process isn’t necessarily simple or cheap. And of course, there are risks involved.
If you’re looking to start a business, you might be eager to use your 401(k) funds to get your business off the ground, but it’s something you should consider carefully.
“Make sure that you have a firm and well-planned strategy in place, and that there is an actual demand for your product or service in the marketplace,” Sims says. “Don’t be biased by your ’desire’ for your business to work, but give an objective view of your business and market, and decide whether risking your financial future is worth the potential reward.”