How To Use 401 Financing For Your Business Acquisition
You have many options for attaining the funding you need to finance a business acquisition. But if the idea of hefty loans and debts to third parties makes you feel uneasy, consider another option. Use your own money to fund all or part of your acquisition, especially through a 401 financing option.
There are three ways you can use your retirement accounts to cover the costs of your purchase:
How Does A Robs Rollover Work
Of course, you will want to do plenty of research, talk to a specialist, and determine if you want to roll over your retirement in order to start a business. Talking to our experts at Collin SBDC is a great start. Here is a basic idea of how a ROBS Rollover works:
- A C Corporation is formed for the new business.
- A new 401k plan is created for the new business.
- Your retirement monies are rolled over, into the new business 401k and are used to purchase stock in the new business C-Corporation.
- A roll-over allows you to forgo paying taxes on your 401k earnings.
Retirement Funds & The Robs Solution
The ROBS solution is basically the only way one can use retirement funds to invest in a business they will personally be involved in. Although a Self-Directed IRA allows one to make passive investments with retirement funds, it does not permit one to use IRA funds to invest in any business that the IRA holder or any disqualified person will personally be involved in, directly or indirectly. In other words, if one wants to use former employer 401 funds or IRA funds to buy or start a business that they or a family member will be personally involved in, the ROBS solution is essentially the only way to do it
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Most Business Owners Dont Think About This
Most people dont even think about tapping their retirement account. They just jump to the small business loan options. There are different reasons for this.
For example, maybe they are concerned about interest rates if they start borrowing money from their retirement accounts. The truth is, that is not exactly how it works. If you do take a loan from your retirement plan, you will pay interest, but to yourself.
Is It A Good Idea To Borrow From Your 401
Using a 401 loan for elective expenses like entertainment or gifts isn’t a healthy habit. In most cases, it would be better to leave your retirement savings fully invested and find another source of cash.
On the flip side of what’s been discussed so far, borrowing from your 401 might be beneficial long-termand could even help your overall finances. For example, using a 401 loan to pay off high-interest debt, like credit cards, could reduce the amount you pay in interest to lenders. What’s more, 401 loans don’t require a credit check, and they don’t show up as debt on your credit report.
Another potentially positive way to use a 401 loan is to fund major home improvement projects that raise the value of your property enough to offset the fact that you are paying the loan back with after-tax money, as well as any foregone retirement savings.
If you decide a 401 loan is right for you, here are some helpful tips:
- Pay it off on time and in full
- Avoid borrowing more than you need or too many times
- Continue saving for retirement
It might be tempting to reduce or pause your contributions while you’re paying off your loan, but keeping up with your regular contributions is essential to keeping your retirement strategy on track.
Long-term impact of taking $15,000 from a $38,000 account balance
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How To Use A 401 To Start Or Buy A Business
Tom has 15 years of experience helping small businesses evaluate financing and banking options. He shares this expertise in Fit Small Businesss financing and banking content.
This article is part of a larger series on Business Financing.
There are three ways you can use your 401 to start or buy a business. You can cash out funds, borrow against your 401, or use a rollover for business startups . The only option that does not result in penalties, taxes, or interest charges is a ROBS, making it ideal for most situations.
If you are considering using retirement funds to start a business, a ROBS allows you to use savings in your 401 or individual retirement account with no penalties or immediate tax obligations. If you have at least $50,000 in your retirement accounts, Guidant will offer a free ROBS consultation.
Why You Would Need To Use Your 401
One of the major drawbacks to traditional funding is the amount of time it can take to secure funding depending on the organization, getting the money in your hands can take weeks or months. This is impractical when business-owners have time-sensitive deals putting off plans for a few weeks can financially destroy a startup.
Using your 401 allows for immediate funding without the hassle of dealing with loan offices. These offices may even deny you a loan after the process begins, slowing down funding even further.
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Purchasing Stock With 401 Funds
After a successful 401 funds transfer to your new corporation, you have the green light to invest this money in your companys stock. By doing this, youre essentially buying shares of your own business to fund its operation.
According to Forbes, the IRS has upheld the legality of this procedure, even though its controversial and subject to IRS audit. The ROBS plan capitalizes on a certain exception in the tax code that allows someone to use rollover 401 funds for buying stock in a C-corp, after which the C-corp can use the funds from the sale of stock to purchase business assets.
The IRS acknowledges that although ROBS plans do not constitute abusive tax avoidance transactions, they may be questionable transactions because of how they benefit a single individual. Because of this eyebrow-raising caveat, make sure you keep the details and transactions of your new business startup in alignment with IRS regulations when structuring your ROBs plan.
Borrowing From A 401 Or Ira To Start A Business
Those who have a 401 can borrow up to $50,000 or half of the vested plan, whichever is less. Loan terms on 401 loans are five years with interest paid to your retirement account. You can also withdraw funds from your 401 for up to 60 days without penalty, provided you fully repay the funds.
You are allowed to borrow money against your 401, and even though there are monthly interest payments of around 8%, the interest is repaid in the form of increased contributions to your retirement account. If you need less than $50,000, borrowing against your 401 makes sense. A ROBS is a more cost-effective choice if you need more than $50,000.
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Benefits Of Using Retirement Funds For 401k Business Financing
First, you can get 24-hour pre-approval. Furthermore, there are no penalties for the rollover. In addition, you pay no application fees.
Bad credit will not get in the way of using retirement funds in this way, and the time from application to funding is 3 weeks or less. A big bonus is this type of funding will report to the business credit reporting agencies. That means you build business credit!
Getting retirement funds this way from your 401k is better than a retirement plan loan. Why? Unless you are 59 ½ years old, there is an early withdrawal penalty of 10% for a loan. That means, you would be paying a lot to use your own retirement savings. Thats your money that you have already worked hard to earn. Dont pay to use your retirement assets if you can help it.
Irs Favorable Determination Letter
Providers and promoters of ROBS court prospective business owners, sometimes by requesting a Favorable Determination Letter from the IRS. The FDL is a way that providers try to assure a client that the IRS approves of the clients ROBS plan. The IRS typically issues a letter, but its based on acceptable compliance of the clients ROBS plan. This letter is neither a blanket approval of the plan nor legal protection if the plan is incorrectly set up or administered.
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Using A Solo 401 To Help Fund Your Business
The Bureau of Labor Statistics recently reported that over 3 million people voluntarily left their jobs each month in 2019. Many people who quit their full-time jobs leave their employers to start and run businesses of their own.
In my work educating business owners about their funding options, one challenge I see new entrepreneurs face is getting capital for their venture when their business has no track record. Getting traditional financing from a bank can be tough in such a situation. Banks typically provide a line of credit or a term loan to finance a company. However, that can be challenging for new businesses that have no revenue, no established credit or no filed business tax returns. If one doesn’t qualify for a business line of credit or a term loan, then the bank may end up providing a personal credit card application. This leaves many new business owners with no choice but to use money from their savings, borrow money from friends and family, use credit cards or tap into their home equity to finance their business.
Those who would like to start a new business and who come from the corporate world with a 401 plan should be aware of another option. If the new company does not have any W2 employees , there is a lesser-known strategy to fund their business that doesn’t involve working with banks or borrowing money from friends and family.
Business Owners: How To Design Your Companys 401 Plan Features
If your company offers a 401 plan to its employees, you may not realize how many options you have that can benefit your personal retirement as the owner. I often work with companies that have had 401 plans in place for years, never realizing how many levers they could pull. In this article, Im going to review a few of the basic ways that the features of your 401 fit into the larger picture.
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The Steps To Take Out Your Money
Youll need to contact your 401 administrator and fill out a form with the requested amount of money. Typically, business-owners can find these forms online and fill them out quickly, receiving the money in their next pay period. Alternatively, you can speak to your current companys human resources department for specific instructions for the fastest way to receive the funds.
Option : Taking Out A 401 Loan
If you have determined the ROBS method might not be for you, you can always buy your business with a loan taken from your 401. In many cases, this can provide a significant advantage over other loan types as you are lending yourself the money while putting up your own collateral. You should discuss the best way to process this loan with your plan administrator.
Taking out a 401 loan is also much easier than pursuing a ROBS strategy. Just like ROBS, you are able to take a 401 loan without incurring penalties from the IRS. You still pay interest on the loan but you pay it back to the lender , so the interest paid will be paid back into your own account. This alone makes it a better option than a private business loan and the resulting business debt.
Working with a qualified accountant can save time and money when dealing with taxes
You are able to take a loan for $50,000 or as much as 50% of your savings, within a 12-month period. The loan itself has an amortization period of five years. If for some reason you fall behind on the loan, it may be reported to credit bureaus, which could lower your credit score. If you truly cant repay the loan, the IRS requires you not only to pay taxes on the defaulted amount, but you incur an early withdrawal penalty of 10% if youre under 59½ years old.
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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.
How A Robs Works
A ROBs makes sense for individuals with over $50,000 in retirement assets who intend to work in their business full time. A ROBS can be a great way to fund the establishment or expansion of your own business without borrowing money or raising equity.
For a ROBS to be a good financing option, you need to:
- Work full-time in the business: If you plan on keeping outside employment or investing passively in the business, you will not qualify for a ROBS.
- Have enough retirement assets to start or buy a business: A ROBS will help you finance your business without having to take out a loan or accumulating business debt. A ROBS can also work well with additional financing to lower your overall debt.
- Identify a good provider: Using a knowledgeable provider can make the process more efficient and help ensure that your ROBS is compliant.
Some additional ROBS qualifications include:
- You have an eligible retirement account: Both a traditional 401 and IRA are eligible, but you cannot use a Roth IRA for a ROBS. Your retirement account must be a tax-deferred account and needs to be more than $50,000 to be worth the setup fees.
- Your business is a C corporation: You must have your business registered as a C-corp. This is because the business is selling shares to a 401 account.
- You must offer a retirement plan to eligible employees in your business: A ROBS provider will help you set up and, in many cases, administer a retirement plan for your eligible employees.
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How To Use 401k Retirement Funds To Buy A Business
Many entrepreneurs are shocked to learn that the IRS allows you to use your former employer 401 funds or even your IRA funds to buy or start a business. This article will explore how the ROBS structure will allow you to start or fund a business you can run, manage and even earn a salary from. If you are leaving your job or plan to leave your job and have a qualified 401 retirement plan, then the Rollover Business Start-Up Solution will likely be the most tax advantageous solution for you.
Robs Vs Retirement Plan Loans
All of this being said, however, one of the biggest and most important differences between a retirement plan loan and a ROBS is that a ROBS isnt a loan. The appeal of a ROBS, then, is that by using one you wont have any debt to pay backânot to yourself and not to a third party.
However, just as is the case with 401 loans, using a ROBS poses the risk of losing retirement funds. If you roll over money into your business and the business doesnt do well, you could lose your retirement savings. Plus, since theres no ceiling on the amount of money you can use with a ROBS, that actually creates greater risk. If your business doesnt do well, you could potentially lose all of your retirement savings, not just a subset.
Moreover, there are other disadvantages that are unique to a ROBS: Setting up a C-corp and a new retirement plan isnt simple, you need to comply with numerous legal rules to avoid hefty tax penalties, and theres a slightly elevated risk of an IRS audit when you do a ROBS.
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Robs Can Fund Franchises
Senior tax analyst Dick O’Donnell notes that many people think 401 business financing is particularly suited to funding franchise startups. Franchises are typically associated with successful businesses that have proven track records, while a small mom-and-pop startup business leans more toward speculation and sentiment than concrete statistics.
Unique Business Financing Option
The program is unique. You can tap into your existing retirement account without penalties or tax consequences. You also avoid loans and traditional banks, and a good credit score is not required. There is no debt and no monthly payment.
With this financing option, you can get capital without the interest payments that would come with borrowing money directly from a traditional IRA or from Roth IRAs. Plus, if youre under the age of 59 1/2, then you can use your IRA or 401k without having to pay any early withdrawal penalties.
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