Accessibility Of 401 Funds
The 401 plan has some great features, such as tax-deferred status, matching contributions and catch-up provisions for older savers. That said, one of their drawbacks is lack of accessibility. The structure of a 401 account is different from that of a traditional individual retirement account .
While an IRA is held in the name of the account holder, a 401 account is held in the name of an individual’s employer on the individual’s behalf. The specific 401 plan offered through the employer governs the circumstances under which individuals can withdraw money from the account, and many employers only allow early withdrawals in the event of severe financial hardship. This basic structural fact regarding 401 accounts is one of the main factors that present obstacles to using account funds as collateral for a loan.
One of the other primary reasons stems from the fact that these accounts are specifically protected from creditors by the Employee Retirement Income Security Act, or ERISA. Therefore, if a 401 were used as collateral for a loan, the creditor would have no means of collecting from the account in the event the borrower defaulted on the loan payments.
How Borrowing From Your 401 Works
Most 401 programs let you set up a loan all on your own, without any assistance, via the website you use to handle other 401 tasks, such as changing your contribution amounts and allocating your savings to different investment funds.
Setting up the loan is as simple as finding the loan page on the 401 site and specifying the amount you want to borrow. The online form won’t let you borrow more than you’re entitled to, and interest rate and payroll deduction payments based on a standard five-year repayment period will be calculated automatically.
Once you authorize the loan, the amount of the loan will likely be included with your next paycheck .
If you have any questions about the process, you’ll find an option for contacting fund administrators on the webpage.
Borrowing Money From Your Own Business
One of the benefits of owning ones own business is the ability to use a separate taxable entity to transfer sums and borrowings back and forth for various economic purposes. While such key issues as your fiduciary duty to minority shareholders and third parties must be kept in mind, it is common for small business owners to both borrow and lend sums to their own businesses as well as borrow sums from their 401K Plan. This article shall deal with some common tax traps that small business owners encounter when using this useful tool.
Such borrowings, while permitted, must be carefully structured to avoid tax liability issues as discussed in this article. Before undertaking these steps, advice from a good accountant and corporate legal counsel would be critical.
The reader should review the article on Limited Liability Entities before reading further.
Tax Danger of the Informal Loan.
Owners of closely held businesses often borrow from their firms. But take great care when doing that, or you may face the wrath of the Internal Revenue Service.
Even if the financial statements classify the withdrawal as a loan, the IRS has the authority to re-characterize it as a dividend or distribution thus taxable to the recipientand perhaps not deductible to the corporation. A recent U.S. Tax Court case illustrates how dangerous no-arm’s length transactions can be when a controlling shareholder borrows from a corporation.
Steps to Avoid the Danger:
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Establishing A Retirement Plan
Working with your business attorney, set up a retirement plan for your new C-corp. You dont have to roll over your 401 funds to another 401, although thats one of the retirement plan rollover options. You can also use a profit-sharing plan, a defined benefits plan, a defined contribution plan or even a combination of these plans. Certain business-specific factors determine which plan is best for your new startup, such as the number of employees and the number of highly paid employees.
Youll also need to appoint a custodian to manage the retirement plan you choose, which is another decision your attorney can help you facilitate.
Fast Process For Receiving Funds
Once the ball is rolling on your ROBS plan, it’s generally a short time frame before receiving your startup funds. You may have funds in hand in less than a month, sometimes as soon as two weeks. If you’re negotiating a startup business deal, such as buying a franchise, or wanting to purchase inventory during a seasonal markdown, a fast turnaround time can make all the difference in closing important deals.
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Open Business Owners Retirement Savings Account
1
Find a CPA that administers Business Owners Retirement Savings Account rollover Individual Retirement Accounts. This is a specialized IRA that allows the IRA to buy stock in a personal corporation. The CPA will not only set up the account, but must become the plan administrator.
2
Open a rollover IRA with the CPA designated as the Business Owners Retirement Savings Account.
3
4
Open a corporation in the state you reside in through the secretary of state. File articles of incorporation and pay any registration fees.
5
Instruct the CPA rollover administrator to buy stock in the new corporation. The money goes into the company operating accounts and the corporation sends the stock certificates of ownership to the CPA to hold in the IRA. Use the assets in the general operating account to purchase the new business.
References
Can You Use Your Ira To Start A Business
Jeff Rose, CFP® | September 07, 2021
Many years ago I had met with a gentleman who was losing his job.
Instead of giving up and adopting the woe is me mentality, he had bigger plans. He wanted to start his own business.
You go with your bad self!
Note: I didnt actually say this, but I was definitely thinking it. I love it when people are willing to take risks and try new things.
One of those risks is something that makes most financial planner cringe.
This inspiring entrepreneur wanted to use his retirement account as funding to start his business.
Stuff like this makes most advisors uncomfortable in their seats.
I have to admit that I shifted a bit, too. If you are thinking of starting a small business and wondering if you can get funds from an IRA to help fund your business, the short answer is yes. It is however, a complicated process and not one that many financial experts would recommend. It is not as simple as withdrawing the funds, as one might think. Here is a look at what you would need to use your IRA to fund your new business venture.
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Should You Tap Your 401 To Start Your Business
Thousands of Americans are using retirement savings to start new businesses. Some thrive, others founder. Is the gamble worth it?
Five Years LaterWhat happens to Entrepreneurs who use their retirement funds to start businesses? To find out, we caught up with four Entrepreneurs who had used their nest eggs to launch franchises in the mid-2000s. Here’s what they did and how it turned out. –J.B.
Entrepreneur: William Mitchell, Charlotte, N.C.In 2005:Took $200,000 out of his 401 plan to help pay for his Primrose School at Eastfield Village, which provides day care and after-school programs for 170 children.
Determine How You Will Pay Back The Loan
Again, this is plan specific. For my plan, there are two types of loan: General Purpose Loan vs. Principal Residence Loan.
- General Purpose Loan has a repayment term of 12 to 60 months
- Principal Residence Loan has a repayment term of 61 to 360 months
Both loan repayments are automatically deducted from each paycheck after taxes. Depending on the amount you borrow, and the repayment term, the amount deducted from each paycheck will be different. For example, for a $25,000 loan, these are the repayment amount that will be deducted from each Bi-Weekly paycheck:
- 12 months term = $1,074.53
- 48 months term = $277.98
- 60 months term = $228.47
In general, you should pay back as quickly as possible while not putting yourself in further financial jeopardy.
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Considerations For Using Your Ira For Start Up Business
First, while the IRS has not yet considered these transactions to be illegal, they do look at them very carefully. There are compliance issues that you are supposed to meet and challenges that could occur if they were to look at stock valuation. If the IRS was to decide that what you did was in the wrong, they could issue a 100% tax penalty. Using your IRA funds in this manner to start up a small business is really in a grey area and no one knows for sure when it may turn black and white. It is hard to know what the IRS will do next or when they will issue penalties or deem that what you have done is illegal.
If you decide to go ahead and use your IRA to help fund your new small business, you will want to tread on careful ground, as you could be putting your IRA at risk. You may instead want to look at other options that are considered totally legitimate. This could include using a home equity line of credit, getting a loan from a family member or even taking out a loan from your 401K at work, if you are still employed. You could also withdraw the funds from a Roth IRA, as long as the account is at least 5 years old.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The Benefits Of Buying Your Own Business With Retirement Funds:
- Neither taxes nor early distribution penalties apply under the Rollover Business Startup transaction because the funds that were transferred from your former employer plan and/or IRAs are directly rolled over into the new ROBS 401k/PS which are then invested in your own C-corporation.
- Because the use of 401k funds to buy a business is not considered a 401k participant loan but rather a stock purchase, you do not have to contend with paying back a loan, which can be challenging during the initial years of the business.
- Securing funding for your business purchase usually takes 14 to 21 days.
About Mark Nolan
Each day I speak with energetic entrepreneurs looking to take the plunge into a new venture and small business owners eager to take control of their retirement savings. I am passionate about helping others find their financial independence. Having worked for over 20 years with some of the top retirement account custodian and insurance companies I have a deep and extensive knowledge of the complexities of self-directed 401ks and IRAs as well as retirement plan regulations. Learn more about Mark Nolan and My Solo 401k Financial > >
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Better Alternatives To Borrowing From 401
As you can see, the price for borrowing from your 401 could be very steep. But what are some of the options you have if you need the money? Here are a few ideas:
- Reduce your expenses This is probably the easiest way to free up some money. Are there any recurring expenses that you could reduce? Are there any planned expenses, such as a vacation, that you could defer? Are you practicing frugality?
- Increase your income Looks for things that you could do to generate income. There are many ways to do this ranging from building alternative income streams, working a second job, and selling your possessions.
A Bad Lending Environment And Provisions In The Tax Code Make Tapping Retirement Funds A Tempting Start
Were you laid off over the past couple of years and sick of the job-hunting circus? Have the itch to start up your own business but know there’s no chance in hell you’re getting a bank loan? Tired of watching your retirement funds whipsaw with the stock market?
If you answered “yes” to these questions – and there are surely a lot of you out there in this economy – you might already be considering tapping into your 401 to start a business. And thanks to provisions in the tax code, you can do so without penalty if you follow the right steps.
But don’t get too excited: This financing technique isn’t for everyone. Here’s what you need to know.
Financing a Start-Up with Your 401: The Process
The steps to financing a business with your retirement savings are simple enough, but legally are a bit complex. The first action is to establish a C corporation that has created but not issued stock. The corporation then adopts a retirement plan. Specifically, what you want is a profit-sharing plan that allows 100 percent of the plan assets attributable to rollovers to be invested in employer stock.
A 401 can be tailored to meet these needs. Then, you rollover your retirement funds from your previous employer or IRA into the new 401 plan. The funds can come from multiple sources and even multiple people – maybe a spouse who will also be part of the business or former co-workers who were also laid off and are looking for a new opportunity. This can help you limit your risk.
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Capitalizing Your New Startup
With your seed money now in hand because of your 401 business financing, youre ready to capitalize your new startup. You can use funds for working capital, business acquisition, paying employees or even as a down payment for additional financing the IRS sets no limits on the use of ROBS funds, with the exception that they cannot be used for your personal expenses that only benefit you.
Tailored Funding Options For You
If you use a self-directed IRA to invest in a business, you cant be involved in running the business because this is considered interacting with the plan assets, which is a prohibited transaction. Self-directed IRAs also dont let you draw a salary from the business. Youll never be able to possess more than 50 percent individual or personal ownership in the business.
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What Are The Benefits Of A Robs Rollover
There are several distinct advantages for using your retirement proceeds to fund your new business:
- Avoid a Tax Penalty: You are not withdrawing the funds. The cash you receive is from the proceeds of sale of your stock to your 401K plan. The great news for those who are under 59 ½ years of age: you avoid the 10% early withdrawal penalty, and the taxation of the distribution.
- No new debt: You will not be taking on new debt that needs to be repaid with interest.
- Great alternative financing: Potential business owners who otherwise would not qualify for a loan have an alternative.
- Quick cash infusion: Can receive funds for your business in a few weeks, instead of months.
Use The Funds To Operate Your Business
Once the QES transaction is complete, your retirement funds can be used by the corporation to begin operating and paying for business expenses! The retirement plan now owns the corporation, and the corporation is cash-rich from selling QES stock.
While the ROBS structure can be complex, the end result is your ability to buy or start a business without going into debt or collateralizing your home. For a more in-depth explanation of the ROBS structure, check out our Complete Guide to 401 Business Financing.
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Set Up A Retirement Plan For Your New Business
The new retirement plan can be established as a 401, a profit-sharing plan, a defined benefits plan, or a defined contribution plan. Roth accounts do not qualify for ROBS. A custodian, such as Charles Schwab or Fidelity, would manage the active parts of the retirement plan. Your ROBS provider would be able to recommend several custodians from which to choose.
What If You Can’t Pay Back A 401 Business Loan
In an ideal world, you would borrow money from your retirement plan, see your business grow, and comfortably be able to pay back the money with interest within the five-year deadline. But things dont always work out as plannedâ your companys cash flow might not be as strong as you hoped, or personal financial emergencies might come up.
If you miss multiple installment payments or are unable to pay back the loan within the time frame set out in your plan documents, the loan goes into default. In this case, the IRS will treat the money you took out as a withdrawalâmeaning that if youre under 59 ½ years of age, youll have to pay income taxes on the money plus a 10% early withdrawal penalty.
Theres one piece of good news, howeverâeven if you default on the loan, the plan administrator cant report this default to the credit bureaus. Therefore, unlike a defaulted mortgage or student loan, which will impact your credit score, your default on a 401 loan shouldnt hurt your ability to get financing down the line.
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Do I Need To Pay Back A Robs Rollover
A ROBS rollover is not a loan, so technically speaking, you do not have to pay back a ROBS rollover ever. However, it is still a good idea to participate in a retirement plan or 401k. The good news is you will have created a company 401k with your new C-Corporation in which you and your employees can invest.
At the Collin SBDC, we can help individuals and businesses in Collin and Rockwall County with how to start or fund a small business. To find out if you qualify for our free service, you can fill out the form HERE.
For additional resources on ROBS Rollovers, how to use your retirement fund for a new business and how to apply, please contact our experts at the Small Business Development Center SBDC serving Collin and Rockwall Counties, Texas.
