Entrepreneurs often need extra cash, and approaching a lender could seem to be a logical step. However, if you have money in your 401(k), you could consider using these funds instead.
But is this really a good choice? Is it wise to use your retirement savings in your business? What if your firm incurs a loss and depletes your nest egg? If you think that using these funds carries risk, you’re right. But the fact is that many company owners use their 401(k)s to finance their businesses.
Let’s see how this works and whether you should seriously consider this source of capital.
Using your 401(k) – 3 options
There are three ways to access your 401(k) funds:
- Taking a cash distribution from your 401(k)
- A 401(k) loan
- Using a ROBS (Rollover as Business Startup)
Let’s briefly examine each.
Option 1 – Taking a cash distribution from your 401(k)
Withdrawing funds from your 401(k) could seem to be the most straightforward and direct option. However, it can also be the costliest way to arrange funds for your business. Avoid this method if you can.
But if you are desperate for money, and decide to take a cash distribution from your 401(k), it’s important to understand the implications of this step:
- Your plan administrator will probably withhold 20% of the amount that you are taking out. This will be sent to the Internal Revenue Service to pay the federal taxes that are due on the sum that you have withdrawn. You could be liable for state income taxes as well.
- Unfortunately, that’s not all. You may also have to pay the IRS a 10% penalty.
Overall, it’s an expensive option that you should try and stay away from.
Option 2 – A 401(k) loan
Taking a loan against your 401(k) is a little better than a cash distribution, but this method also comes with its share of disadvantages.
Here is a broad overview of how a 401(k) loan operates:
- Who’s eligible? This depends upon your retirement plan’s rules. Check with your plan administrator if you qualify for a loan against your 401(k). If a loan is permitted, the amount that you can borrow will be restricted to $50,000, or half the sum in your 401(k), whichever is lower.
- When should you take it? Borrow against your 401(k) only if you are sure that you will be able to repay. If you default on the repayments, the Internal Revenue Service will treat the loan as a withdrawal. This means paying taxes on the sum and maybe even a 10% penalty.
- How does it work? The loan term is usually five years. The interest rate could be in the 8% range. But there is one issue that you should be aware of. If the 401(k) that you are borrowing from is sponsored by your employer, additional conditions apply. So, for example, if you leave your job, you will be required to repay the entire loan amount within 60 days. Not doing this could lead to the loan being considered to be in default.
Here’s a summary of the pros and cons of taking a loan for your business from your 401(K):
- It could be a simple and effective way to get money for a side project.
- The interest on the loan is not a cost because you are effectively paying it to yourself. The interest amount that you pay goes directly to increase your 401(k).
- You could avoid the taxes and the penalty that a cash distribution from your 401(k) involves.
- Since it’s a loan from your own funds, there is no need to go through a credit appraisal process.
- If you can’t pay back, at least some of your retirement savings will still be available. Remember that the maximum you can borrow is limited to $50,000, or half your balance, whichever is lower.
- If you are an employee, this method of raising money for your business only works if you plan to continue working. If you quit your job, you will have to repay the entire loan within 60 days.
- An inability to pay back the loan (even though you have borrowed from yourself) can prove to be expensive. The borrowing will be seen as a withdrawal from the 401(k), and you will have to pay tax on it in addition to possibly being liable for a 10% penalty.
- Raising the money from your 401(k) may involve the payment of administration fees. This will add to the overall cost.
- If your business operations incur a loss, you could lose a big chunk of your retirement savings.
- There’s a limit to the amount that you can raise. The maximum that you can borrow is $50,000.
Option 3 – Using a ROBS (Rollover as Business Startup)
This is probably the best way to raise money from your 401(k) for your business. It’s a complex procedure, and you will need professional help to access your retirement funds. The first requirement is that you must have a C-corporation. This is a corporation that is taxed separately from its owners.
This is how it works:
Step 1 – you have to establish a 401(k) for the C-corporation.
Step 2 – your 401(k) funds are rolled over into the new company’s retirement plan.
Step 3 – the 401(k) money is used to purchase stock in the C-corp.
Step 4 – now these funds are available to use as you wish.
As you can see, it’s a complicated procedure. It involves an initial upfront cost payable to the ROBS provider. This could run into thousands of dollars. In addition to this, you will need to make regular payments to ensure that you remain compliant with the applicable regulations.
Here’s a summary of the pros and cons of using a Rollover for Business Startups to raise money for your business:
- This method doesn’t involve taking a loan. So, you don’t have to make any repayments.
- You can access all the funds in your 401(k).
- Accessing money from your 401(k) doesn’t involve paying taxes or penalties.
- This could be the best use for your retirement funds. If your business is successful, the returns on your money could be far higher than the rate you would have earned if the funds remained in your 401(k).
- It’s expensive. You would be required to spend thousands of dollars initially to set up your C-corp and transfer your 401(k). There would be additional recurring expenses as well.
- If your business makes a loss, you could lose your retirement savings.
- As the owner of the business, you would have to take on additional responsibilities. It would be necessary to familiarize yourself with the rules and regulations governing C-corps.
- The option of using a ROBS is only available if you are planning to become a full-time entrepreneur. You can’t keep your regular job as an employee and access funds from your 401(k) by using a ROBS.
Do you have any other options?
What if you don’t like the idea of risking your retirement funds? Is there any other way to obtain capital for your business?
The answer is a resounding YES!
You can take a small business loan from Camino Financial. These are available with a wide range of attractive features. Some of the benefits are listed here:
- Collateral-free loans – Business loans from Camino Financial are unsecured, meaning they don’t require you to put up any collateral. l Your retirement funds, personal assets, and your business equipment is safe.
- A chance to build your credit history – If you pay your installments on time, your credit score will see improvement.
- The possibility of graduating to a better loan – Regularly repay for only nine months and become entitled to an additional loan for a higher amount and at a lower rate of interest.
- Fast loan disbursals – From start to finish, the entire loan process takes only four to ten days.
- Borrow the amount that you need – Camino Financial offers loans from as little as $5,000 to as much as $400,000, so they adapt to any of your business needs.
- Simple and easy-to-meet eligibility criteria – You can apply for a Camino Financial loan if you have been in business for nine months and have annual sales of $30,000 or more. Camino Financial accepts applicants who only have an ITIN.
- Knowledgeable business loan specialists – You will receive help from a dedicated loan specialist who knows your industry, needs, and goals. Camino Financial will guide you in choosing the best loan product and throughout the borrowing process.
- Access to tools, resources and exclusive webinars – We encourage you to continue your education in finances and business management. And the best part: it’s free!
How can you find out if you qualify for a small business loan from Camino Financial? It’s simple. All that you have to do is to take out a few minutes to fill this online application.
The bottom line
So, should you use funds from your 401(k) for your business? In most instances, it’s advisable not to do so. The money in your 401(k) is intended for the period during which you will no longer be working, and you should retain it for its original purpose.
In fact, retirement planning for small business owners is a crucial issue that deserves your attention. An early start will help you to maximize your retirement funds.
But what about your immediate business needs? Where will the money come from? A small business loan from Camino Financial could be your best option. You can request a quote today or contact a Camino Financial business loan specialist right away for more details. The advice that you get is free, and you have no obligation to take a loan.