Essential 401 Startup Steps
Youll have to follow an exact protocol to take advantage of the ROBS plan and use 401 funds for your business startup, tax- and penalty-free. First, youll need to create a C corporation and set up a retirement plan for it. After these two fundamentals are in place, youll roll over your existing 401 funds to the new retirement plan youve just set up for your new company. With these newly rolled-over 401 funds, youll then purchase stock in your own new company to capitalize its financial needs.
Is Your 401 Protected If Your Employer Goes Out Of Business
If you invest in your companys 401 plan, you know that your pre-tax savings comes out of your paycheck each period and is invested in one or more investment vehicles, usually mutual funds. But you may wonder if your employer ever sees any of that money, other than any contribution it may provide. Very simply, your employer is not legally allowed to hold your 401 money. Under federal law, all 401 money must be held in a trust or in an insurance contract thats separate from your employers assets. Therefore, neither your employer nor any of your employers creditors can grab that 401 money.
That said, there are certain circumstances in which you may not receive all the funds you expected if your employer goes out of business.
Should You Use A 401 To Pay Off Debt
As we all know, 401 plans are a great way to save for retirement. However, if you have a lot of debt, cashing out your 401 is an option but…
As we all know, 401 plans are a great way to save for retirement. However, if you have a lot of debt, cashing out your 401 is an option but is it a good option? In this article, we will discuss all the pros and cons of using your 401 savings to pay off debt. We will also explore some alternative methods for paying off debt so that you don’t have to rebuild your retirement fund from scratch.
Due – Due
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Solo 401 Plan Components
There are two components to the solo 401 plan: employee elective-deferral contributions and profit-sharing contributions.
- Employee Contribution Limits: You may make a salary-deferral contribution of up to 100% of your compensation but no more than the annual limit for the year. For both 2020 and 2021, the limit is $19,500, plus $6,500 for people age 50 or over.
- Employer Contribution Limits: The business may contribute up to 25% of your compensation but no more than $58,000 for 2021 . An employee age 50 or above can still contribute an additional $6,500 for 2020 and 2021.
How Borrowing Against A Traditional Ira Works
Neither traditional nor Roth IRAs allow loans like a 401 plan may. Both account types permit penalty-free distributions in some circumstancessuch as paying for educationbut there is no penalty-free distribution for starting or buying a small business.
You can withdraw funds from your IRA for up to 60 days without penalty. If you cannot pay the money back within that 60-day window, it will count as a distribution from your account, and you will be taxed as if you cashed it out . Each IRA account only allows you to do this one time within a one-year period. In this case, borrowing from a traditional IRA is very much like a short-term loan, provided funds are paid back within 60 days.
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What Are The Penalties For Withdrawing From My 401 Before Age 59
Unless you fall into one of the special exemption categories, you will pay a penalty of 10% of the amount of funds you withdraw. This can get quite pricey and really cut into your retirement savings. If you must make a withdrawal before reaching retirement age, then make sure you check the list of exemptions to the penalty. If you can qualify under one of the exemptions, then you will not be forced to pay this extra penalty.
Finance: Can I Use My 401 To Start A Business
If youve asked yourself this question, you are not alone, and depending on your circumstances,it could be an option worth strong consideration. Using your retirement funds could be a great way to help you start your business debt-free. By Sherri Seiber
For ambitious entrepreneurs debating their best funding options for their business, this question is often posed: Can I use my 401 as an invest-ment fund?
If youve asked yourself this question, you are not alone, and depending on your circumstances, it could be an option worth strong consideration. Using your retirement funds could be a great way to help you start your business debt-free.
But How?By taking advantage of the Rollover for Business Startup strategy. This strategy allows you to access some or all of your tax-deferred savings without early withdrawal penalties and invest it into your business. There are no monthly payments, no income tax consequences, and no reimbursement is required. Your 401 funds could also make for a smart equity injection that a lender may require if you do need to take out a business loan.
And yes, ROBS business funding is legal. The ROBS process is governed by the Internal Revenue Service and the Department of Labor and has been in place since the Employee Retirement Income Security Act of 1974 .
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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.
The Basics Of 401 Withdrawal Taxes
If you are wondering whether your 401 withdrawals are taxed, the short answer is yes your 401 distributions are likely taxable.
This may come as a surprise, because there is some confusion around how retirement accounts work. People often refer to retirement accounts like 401s as tax-advantaged, or tax-deferred. This means investments within your 401 or IRA grow tax-free. Unlike taxable investment accounts, you wont be charged income tax or capital gains tax as your 401 account grows each year.
As an example, if you earn $1,500 before taxes per paycheck, and you contribute $300 of that money to your 401, then you will only be taxed on $1,200. For reference, 401 account holders can contribute up to $19,500 in 2021 , and $26,000 for those 50 and older.
This tax advantage, however, changes once an account holder starts receiving distributions from the 401. As you pull money out, youll owe income taxes on the funds. Some 401 plans will automatically withhold 20% or so of your account to pay for taxes. Youll want to check with your plan provider to see how your particular 401 works.
Wondering when you can start cashing out? Once you reach age 59.5 you can withdraw money from your 401. If you dont need the money yet, you can wait until you reach age 72 to withdraw funds. However, once you reach 72, its no longer a choice to withdraw from your 401, its mandatory. The IRS has defined required minimum distributions for certain retirement accounts, including 401s.
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Can You Invest In Real Estate Through Your 401k
If you have a 401k plan through your employer, the answer is probably no at least not directly. I have yet to find an employer-sponsored retirement plan that allows participants to buy investment properties or participate in crowdfunded real estate investments.
The only possibility of even putting money to work in real estate indirectly in an employer-sponsored 401k would be if theres a real estate investment fund on the plans menu of investment options. For example, the Vanguard Real Estate Index Fund might be one of the funds offered by your plan.
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How Do Robs Plans Work
The concept is fairly simple, your retirement account essentially buys shares of stock in your new business which provides the business with the cash needed to grow. You do not have to be a publicly traded company for your retirement account to buy shares, however, you are required to establish your new company as a C-Corp in order for this plan to work.
This process entails incorporating your new business, as well as establishing a new 401 plan within that business, that contains the special ROBS features. Then, you can transfer assets from your various retirement accounts into the new 401 plan allowing the 401 plan to then buy shares in your new company. While this sounds easy, I cannot stress enough that you must work with a firm that fully understands these types of plans and the funding strategy. These plans are perfectly legal, but there are a lot of rules to follow. Since this funding strategy allows you to access retirement account dollars without having to pay tax to the IRS, the IRS will sometimes audit these plans hoping that you did not fully understand or comply with the rules surrounding the establishment and operations of these ROBS plans.
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Using The Capital To Grow Your Business
Once the share purchase is complete, the cash will be transferred from your retirement account into the business checking account allowing use those funds to start growing the business.
There is a very important rule when it comes to what you can use these funds for within the new business. First and foremost, you cannot use these funds to pay yourself compensation as the business owner. This is probably the biggest no-no associated with these types of plans. The IRS does not want you circumnavigating income taxes and penalties just to pay yourself under a ROBS plan. In order to pay yourself as the business owner, you have to be able to generate revenue from the business. The assets from the stock purchase can be used to pay all of your expenses but before youre able to take any money out of the business to pay yourself compensation you have to be showing revenue.
Once new business owners hear this, its often disheartening. Its great that they have access to capital to build their business, but how do they pay their bills while theyre building up the revenue stream? Luckily, I have good news on this front. We have additional strategies that we can implement using your retirement accounts outside of the ROBS plan that will allow you to pay yourself compensation as the owner and it can work out better tax wise than paying yourself as a W2 income through the C-corp.
Shift Retirement Plan Contributions From Pre
Perhaps the easiest solution to implement is simply changing your retirement plan contributions from pre-tax to Roth. Youll lose the tax deduction in the current year, and you may have to explain to your accountant why you made the change. However, any company match is tax-deferred, so even if you switch to 100% Roth, the employer match and your investment return means the tax-deferred account will still grow.
Many of my clients arent aware they have a Roth option in their 401/403, or they mistakenly think they cant contribute to one because of income limits, but thats not true. Only Roth IRAs have an income limit. So find out if your retirement plan offers a Roth option.
Lets look at the impact of this one action in more detail through the lens of our example 40-year-old couple who previously were maxing out their pretax 401s each year , plus a $6,000 employer match each. If the couple switched all contributions from pre-tax to a Roth 401, only the $12,000 in combined employer match remains as a pre-tax contribution.
The impact is massive.
For younger investors, the best way to defuse a retirement tax bomb, in terms of both impact and ease of execution, is to simply shift retirement plan contributions from pre-tax to Roth. This strategy will be less impactful for those nearer retirement because they have fewer years for the effects to compound.
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What Is A 401
A 401 plan is a retirement savings plan. The money you contribute to your 401 plan is not taxed until you withdraw it in other words, your savings will be tax-deferred as they grow.
There are two types of 401 plans: Traditional and Roth. With a traditional 401, you will not pay taxes on the money that you contribute until you withdraw it. On the other hand, with a Roth 401, you pay taxes on the money you contribute, but you don’t have to pay taxes when you withdraw it in bulk. Another difference between a traditional and Roth 401 is that the former lets you take a loan from your account. With a Roth 401, you cannot touch the savings until you’re retired.
What’s The Cost Of A Robs
ROBS providers charge a one-time, upfront fee and an ongoing administration fee. The one-time fee, which typically comes to around $5,000, covers C-corp and retirement plan setup and issuing the stock certificates. The ongoing administration fee, which is approximately $100 to $150 per month, ensures that youre in compliance with any rules around retirement plan administration. If you use a professional service to help you set up a ROBS, youll then pay any associated fees for their assistance throughout the process.
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Requirements For Robs Plans
There are a few requirements you have to meet for this funding strategy to work.
1) The funds have to be held in a pre-tax retirement account. This means that money in Roth IRAs and Roth 401s are not eligible for this funding strategy.
2) You typically need at least $50,000 in your new 401 account for the ROBS plan to make sense since there are special costs associated with establishing and maintaining a ROBS 401 plan. If your balance is less than $50,000, the cost to establish and maintain the plan begins to outweigh the benefit of executing this funding strategy.
3) If youre rolling over a 401 plan to fund your ROBS 401 plan, it cannot be from a current employer. In other words, if you are still working for a company and youre running this new business on the side, you are not able to rollover your 401 balance into your newly established 401 plan and implement this ROBS strategy. The 401 account must be coming from a former employer that you no longer work for.
4) You have to be an active employee in the business
Retirement Funds Dont Have To Be Off
Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.
For those who invest in their 401 plan, the traditional thinking is to wait until retirement before taking distributions or withdrawals from the account. If you take funds out too early, or before the age of 59½, the Internal Revenue Service could charge you with a 10% early withdrawal penalty plus income taxes.
However, life events can happen, which might put you in a position where you need to tap into your retirement funds earlier than expected. The good news is that there are a few ways to withdraw from your 401 early without incurring a penalty from the IRS.
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Purchasing Stock In The Business
Its not as easy as simply transferring money into the business checking account since you have to go through the process of issuing shares to the 401 account. In most cases, the percentage of ownership attributed to the 401 plan is based upon your total funding picture to start up the company. If your retirement accounts are the sole resource to fund the business, then technically your 401 plan owns 100% of the company. Its not uncommon for new business owners to use multiple funding sources including personal savings, funding from friends and family, or a home-equity loan. In these instances, a ROBS plan is still allowed but the plan will own less than 100% of the business.
I dont want to get too deep in the weeds with this point, but its usually advisable not to issue 100% of the shares of the business to your 401 plan. This could limit your ability to raise additional capital down the road because you dont have any additional shares to issue to new investors or to share equity with a new partner.
Theres An Easy And Effective Way Savers Can Minimize The Damage Of A Retirement Tax Bomb It All Starts With Making One Simple Shift In Your Retirement Savings Contributions
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Editors note: This is part five of a seven-part series. It dives more deeply into the first strategy for mitigating a retirement tax bomb, which is to shift retirement savings from pre-tax to after-tax accounts, including Roths and HSAs. If you missed the introductory article, you may find it helpful to start here.
If youre facing a retirement tax bomb, there are three main strategies to defuse it: shifting retirement savings from pre-tax accounts to Roth and HSA accounts, implementing asset location, and executing Roth conversions.
I consider shifting your savings to be the first line of defense, because its the easiest solution to implement. However, to really get the job done, youll likely need to implement all three strategies.
There are two flavors to shifting savings, one uses Roth retirement accounts, while the other uses health savings accounts .
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