Other Startup Funding Options
Because of the high failure rate of business startups, the Wall Street Journal points readers away from using retirement money, such as a 401 to fund a business, if other funding is available. If possible, use nonretirement assets for your startup and preserve your nest egg. For example, after setting aside a six-month emergency savings fund, use taxable savings or brokerage accounts as seed money for your startup. Other non-401 options include home-equity credit and loans.
If You Think Using Retirement Money To Start A Company Means A Big Tax Payment Think Again There’s A Way Around The Problem
Bohnne Jones worked in the healthcare industry for 33 years until she was laid off in January 2002. Going back to school and picking up expertise in IT gave her a new start, but only a temporary one. A two-year engagement came to an end and then a position as a VP in a software start-up was over in eight months when the company started feeling the first strains of the oncoming global contraction.
Jones wasn’t ready to retire and had a life-long interest in design and decorating. The Decorating Den franchise caught her eye, but she was turned down. “They told me I didn’t have enough money, but I had $330,000 in my 401,” she says. “They said, ‘Oh, we can’t count your 401.’ That’s when I started to scratch my head. What should I do? Cash in my 401?” The tax implications would have been enormous.
But, getting some help, she learned that she didn’t have to cash out. Instead, using a process of creating a corporation and new 401 and rolling the old 401 over into the new plan, she could use her money as capital to both buy the franchise and to fund it. Although the business has had its ups and downs, and she invested a total of $250,000 in two parts, the franchise is now running strong.
1. Establish a C corporation before you create or buy your business. An S corporation, limited liability corporation, or other structures don’t offer the necessary legal framework.
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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Choose A Plan That Meets Your Business Goals
Plan design optionsThe big difference between 401 plan designs is how and when an employer makes contributions on behalf of its employees. Here are three types of plan designs, their requirements, and some other implications:
What other 401 plan features should I consider?Offering retirement benefits is a great way to attract and retain talent. But specific plan features can really boost participation and make your small business 401 plan even more enticing.
Traditional vs. Roth 401. Whats the difference?Generally speaking, the key difference between the two is when employee contributions are taxed. With traditional accounts, contributions are made before taxes are taken out of pay. Under Roth accounts, contributions are taxed first and then deposited. When an employee retires, withdrawals from traditional accounts are taxed at ordinary income rates, whereas Roth withdrawals can generally be made on a tax-free basis.* Read more about traditional vs Roth accounts.
Should I match employee contributions?Matching contributions can be hugely beneficial for both employees and employers. For employees, theyre an additional form of compensation that can help maximize their retirement savings.
‘my Employer’s Match Won’t Make A Significant Difference’
An employer’s match to your retirement plan is essentially free money. This is a guaranteed return on your investment. It doesn’t matter if they match 3% or 6%. Remember that you will be able to benefit from the compound interest on your employer’s match. Enroll to have your contributions automatically deducted from your payroll. Trust me: You won’t miss this money.
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How To Withdraw From A 401k To Open A Business
Starting your own business can be the road to financial freedom, but getting that new business off the ground can be a real challenge. The initial startup phase of a business often requires a large influx of cash, and if you cannot get that money from anywhere else, you might be tempted to find it in your 401k.
Pull out a copy of your most recent 401k statement to get an idea of how much money you have to work with. If you have online access to your account, log on to see the current account balance, as it could be more or less than what is shown on your statement.
Determine how much you need to pull from your 401k to finance your new business. You need to have enough seed money to get started of course, but it is best to take out only what you think you will need. Raiding your 401k can be costly, from a tax perspective and from a future retirement perspective.
Consult with a tax professional or CPA to determine how much tax liability you will incur by taking money out of your 401k. If you are at least 59 1/2 years of age, you can withdraw money from your 401k without penalty, but if you are younger, you will be subject to a 10 percent penalty, on top of the ordinary income taxes you will owe on the money you withdraw. Depending on your tax bracket, those taxes and penalties could consume nearly half the balance of the 401k plan.
Choose A Plan For Your Employees
Once you’ve chosen a retirement services provider, it’s time to decide on a plan that fits both your business and your employees’ needs. Options available to employers regardless of size, including businesses with only one employee, include:
1. A traditional 401 plan, which is the most flexible option. Employers can make contributions for all participants, match employees’ deferrals, do both, or neither.
2. The safe harbor 401 plan, which has several variations and requires the company to make a mandatory contribution to the plan participants. The contributions benefit the company, the business owner, and highly compensated employees by giving them greater ability to maximize salary deferrals.
3. An automatic enrollment 401 plan, which allows you to automatically enroll employees and place deductions from their salaries in certain default investments, unless employees elect otherwise. This arrangement encourages workers to participate in the company 401 plan and increase their retirement savings, which also benefits business owners. Automatic enrollment plans may also contain a safe harbor provision.
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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 options. He shares this expertise in Fit Small Businesss financing content.
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.
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.
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Pros And Cons Of Robs
ROBS should be carefully analyzed from all angles. Here are some important considerations.
Complicated eligibility process, including becoming a C corporation, which has major business implications
Depleting retirement funds is considered risky
Considered questionable by the IRS since they only benefit the business owner, and IRS audits on ROBS businesses tend to be burdensome due to heavy paperwork
Historically used for businesses on the brink of failureand when they fail, owners tend to lose their retirement funds and businesses, according to the IRS
Costly to start a set-up fee costs about $5,000, and about $130 a month thereafter, depending on the plan
Why Should I Consider Using My 401k To Start A New Business
Many new business owners do not want to take on debt that they have to repay with added interest, either from an SBA Loan or from another lending institution. Other potential new business owners lack the appropriate credit score, capital, or funding required to get a loan. ROBS rollover funds can be obtained easily and quickly, when compared to a conventional or SBA Loan and the lack of interest and few penalties makes them a very attractive funding option.
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Specific Problems With Robs
Some other areas the ROBS plan could run into trouble:
- After the ROBS plan sponsor purchases the new companys employer stock with the rollover funds, the sponsor amends the plan to prevent other participants from purchasing stock.
- If the sponsor amends the plan to prevent other employees from participating after the DL is issued, this may violate the Code qualification requirements. These types of amendments tend to result in problems with coverage, discrimination and potentially result in violations of benefits, rights and features requirements.
- Promoter fees
- Valuation of assets
- Failure to issue a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. PDF, when the assets are rolled over into the ROBS plan.
Keep It Running Smoothly
Ongoing nondiscrimination testingOffering a retirement plan takes regular upkeep and a close eye on 401 plan compliance deadlines to ensure you dont run afoul of ERISA and IRS rules. Most 401 plans are required to pass nondiscrimination testing each year. These look at the value of each employee’s account, employee contribution rates, and other details. Employer matching and profit sharing also come under scrutiny. Your company may also want to regularly review or revise your plan features as the company’s situation changes.
Government filingsIn addition to keeping up with compliance testing, youll need to file an IRS Form 5500 each year. This federally-mandated form includes information about your business, your retirement plans, number of participants, and more.
How much will a small business 401 cost?Guideline 401 starts at a $49 base fee plus $8 per employee per month. Learn more about our fees and services here.
When evaluating a small business 401, consider if there are hidden fees for key functions such as compliance, recordkeeping, and investment management. Also ask about setup fees, monthly fees, annual fees, Form 5500 fees, and whether a provider expects you to pay fees to anyone else. All these standard services are included in Guideline’s pricing.
*This content is for informational purposes only and is not intended to be construed as tax advice. You should consult a tax professional to determine the best tax advantaged retirement plan for you.
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If You’re Saving For Retirement One Of The Cardinal Rules Is: Don’t Touch Your 401 Until You Retire
Eric Schneider followed it diligently during his 25 years selling commercial insurance. But two years ago, he emptied his nest egg to launch Headrush Roasters Coffee & Tea in Kansas City, Mo.
“I took a big risk, but I don’t regret it at all,” said Schneider, 49, who co-owns the business with his wife Nancy.
Schneider left his six-figure job in 2010 with $250,000 in his 401 and $100,000 in savings. In 2011, he found a vacant building that he thought would be perfect for his coffee shop and roastery.He hoped to lease it, but the owner only wanted to sell.
“I’m a big believer in no debt,” he said. “I had paid off my house, my cars. I didn’t want to take out a loan to buy the building.”
As he researchedfinancing options, he came across ROBS, or Rollovers as Business Startups. These allow people to use the money in their401to start a business without paying taxes on the withdrawn funds or getting hit with an early withdrawal penalty.
The process can be pretty complicated, however. First, you must incorporate a business and open a new 401 plan under it. Then you roll your existing 401 funds into the new plan. Since both accounts are tax-exempt, you avoid taking the tax hit.
As owner of the new company, you can now direct what the 401 invests in. With ROBS, the new company typically issues shares that you can purchase using money from the 401. You’re then free to use the cash from that purchase for operational expenses funds).
How Do I Create A 401 Plan
Creating a 401 plan for a companyeven a small oneis a complex process. The following is a basic overview of the steps for getting approval and starting the plan:
- Write a plan with the help of a plan adviser and send it to the IRS for a determination letter .
- Find a trustee to help you decide how to invest contributions and manage individual employee accounts.
- Begin making employer contributions, if offered, and allowing employee contributions through your payroll system.
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No Interest No Collateral No Credit Score
401 business financing is an ideal method if you dont want to go into debt, dont qualify for a loan, or just dont have the cash on hand to start or purchase a business. Unlike other types of funding methods, your credit score, past experience, or on hand collateral play no role in eligibility. Instead, the main factors are the type of retirement account or IRA) and the amount of money you have in it .
Research Retirement Options For Your Business
It’s important to do your due diligence in researching firms that provide recordkeeping and third-party administration services for 401 plans. As you assemble your list, include a range of established, reputable mutual fund companies, brokerage firms, and insurance companies. Focus on providers that can serve you and your employees long-term with extensive resources and excellent customer service.
You may also want to hear from owners of businesses that are similar to yours, as they may be able to offer insights from their own experiences selecting 401 plan service providers.
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‘i Don’t Need To Increase My Contributions If My Income Increases’
It is very important to revisit your budget frequently to see if there are any opportunities to save more money. As your income increases, consider setting up automatic increases with your retirement plan. Many plans allow you to set up automatic annual percent increases. This would ensure that your savings rate is constantly growing. Always remember to invest in yourself first.
Some Considerations To Using Your 401
Utilizing your 401 isnt without its downsides if plans dont work out as you intended, they could set back your retirement years. Be aware of how much you have in your account and what that amount will look like if your business is unsuccessful. Youll need to budget for the worst-case scenario: losing money on your investment.
You also need to look at the tax advantage growth and whether leaving the money in your plan or taking it out now is more beneficial. Leaving your 401 alone to grow over time may be far more profitable than using it as a short-term loan.
Taking money out of your 401 plan is a considerable risk, despite the immediate benefits it affords. Many financial experts recommend using it only when you have no other option and, even then, only when you know youll see a relatively quick return. Determine whether you want to use your 401 to start your businessor if you even should.
© Copyright 2021. Pango Financial®, LLC. Pango®, Pango Financial®, the Pango logo, Forging Your Future, and DreamSpark® are trademarks of Pango Financial®, LLC. All rights reserved. A De Novo Corporation company.
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How Does 401 Business Financing Work
401 business financing allows you to tap into your retirement account and use that money to start or buy a business or franchise. To access your money without triggering an early withdrawal fee or tax penalty, a ROBS structure must first be put in place. The structure has multiple moving parts, each of which must meet specific requirements to stay compliant with the IRS.
Using A 401 To Start A Business: What You Need To Know
If youre thinking about using a 401 to start a business, there are a few points youll want to keep in mind before you explore your different financing options.
To begin, youll want to remember that ordinarily, if you withdraw money out of a 401 or IRA before the age of 59 Â½, you have to pay income taxes on the money, plus a 10% early withdrawal penalty. Therefore, if youre wondering how to use your 401 to start a business, youre taking on a considerable amount of risk in doing so.
Luckily, however, short of simply withdrawing money from your retirement account, there are two better options that allow you to tap into your retirement funds without having to pay income taxes or penalties. First, you can take out a 401 loan to finance your businessâor, second, you can rollover your balance into a new 401, called ROBS, or rollovers as business startups.
In both of these cases, although you wont face the same taxes and penalties as taking directly from your account, there will nevertheless be inherent risk involvedâyoull risk losing your retirement savings if your business doesnt do well. Ultimately, whether or not you decide on using a 401 to start a business will depend on your personal level of risk tolerance and what you think is best for your future.
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