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How to Use a 401(k) or Other Retirement Account to Start or Buy a Business

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If you're looking to start or buy a business, one option you may have considered is using your retirement savings, such as a 401(k) or individual retirement account (IRA). There are multiple ways you can tap funds from your retirement accounts, from borrowing to early withdrawal. While using these strategies is not without risks, it is a debt- and equity-free way to get a business up and running.

How Can You Use a Retirement Account to Start or Buy a Business?

Entrepreneurs face the problem of how to fund or purchase their new company. One source of funding is a retirement account—a 401(k), 403(b), traditional IRA, Roth IRA, SEP IRA, SIMPLE IRA and so on. While you can cash out these plans to fund your business, you will have to pay taxes on the withdrawals (with some exceptions for Roth accounts) and, if you are below age 59½, a 10% early withdrawal penalty will be tacked on.

To avoid taxes and penalties, owners might want to have their retirement accounts fund a business directly—i.e., the account owns the business. However, rules by the Internal Revenue Service (IRS) and Employee Retirement Income Security Act (ERISA) make this a difficult proposition. First, the IRS does not want businesses funded by tax-deferred or tax-exempt accounts to have an unfair advantage over businesses that are not so funded. Therefore, most businesses funded by retirement accounts are subject to unrelated business taxable income (UBTI) rules that negate the tax advantage. Passively managed rental properties are one of the few exceptions to the UBTI tax. In addition, there are rules against self-dealing that prohibit retirement account holders from using the account assets to benefit themselves and their families prior to retirement. That said, there are a few ways you can use your retirement funds to start up or buy a business, each with its own pros and cons. Let's take a closer look at each.

Rollover as Business Startups (ROBS) Plan

A ROBS plan is a series of steps to enable retirement account holders to fund a business startup or purchase.

Establish a C corporation: Create a C corporation to hold the shares of the business. It is a legally separate entity from your retirement account.

Create a new 401(k) plan: Set up a self-directed 401(k) plan within the new C corporation. A self-directed plan can purchase alternative assets, including the private shares of your new corporation.

Roll over your retirement account: Have your current retirement account custodian perform a direct transfer to the new 401(k). You can roll traditional accounts tax-free to either a traditional or Roth 401(k), but you can transfer an existing Roth account only to another Roth account, meaning you'd have to designate the new 401(k) as a Roth account.

Buy shares of your new corporation: Use the funds in your new 401(k) to buy shares in your new corporation, thereby self-funding your business.

Pros

  • Fast funding: The procedure can be performed in a few weeks.
  • Deferred taxes: This method, when properly executed, avoids taxable withdrawals from your retirement account.
  • Keep control of capital structure: A ROBS plan might help you avoid turning to a loan (and thus side-stepping loan interest) or avoid selling part of your business to an equity investor, which would dilute your own return and introduce possibly pesky junior partners.

Cons

  • Possible penalties and taxes: You must execute the ROBS plan perfectly to avoid taxes and penalties. That means the corporation and 401(k) must be properly structured, and certain tax forms, such as Form 5500, must be filed with the IRS.
  • Risk retirement savings: Spending your 401(k) this way is risky because your business might fail. This might leave you with an underfunded retirement. You also will forgo the tax-deferred gains you would have otherwise earned on your retirement account assets if you hadn't executed the ROBS plan transaction.
  • C corporation setup may not be best for your business: This might or might not be the most tax-efficient way to operate your business. You'll forgo the opportunity to operate as a sole proprietor, limited liability company, partnership or S corporation.
  • Expenses from third-party custodians: Custodians that specialize in ROBS plans, such as Guidant Financial and Benetrends Financial, charge a one-time fee of about $5,000 plus a monthly fee of more than $100. These fees cannot be paid by your retirement account.
  • Increased likelihood of IRS audit: When you adopt the ROBS plan, you increase your chance of being audited by the IRS, although the added risk might be negligible if you use an established custodian.

Early Withdrawal

You can tap your retirement account at any time; however, you may be subject to early withdrawal penalties if you are under the age of 59½. You also might not be able to drain your 401(k) or 403(b) as long as you are working for the employer sponsoring the account, but you can roll it over to an IRA to access funds.

Pros

  • Quick access: You might be able to get your money within a week or two.
  • Keep control of capital structure: You avoid outside lenders and equity partners.
  • Roth IRA tax benefits: If your retirement account is a Roth account, you avoid taxes (but not possible early withdrawal penalties) on contribution withdrawals.

Cons

  • Taxes and penalties: As mentioned earlier, you face taxes and possible penalties when you withdraw money from a traditional retirement account. The early withdrawal penalty is an additional 10% tax on the funds. You also face penalties when you prematurely withdraw Roth earnings or withdraw Roth contributions held for less than five years. Roth accounts can only be rolled over to Roth accounts.
  • Risk retirement savings: This method has the same risks to your retirement fund as does the ROBS plan.

Borrowing from a 401(k)

You cannot borrow from an IRA account, but you can take out a loan from a 401(k) or 403(b) account. These loans are subject to rules regarding the loan amount, repayment term and interest rate.

Pros

  • Quick access: You might be able to get your money within a week or two.
  • Avoid penalties and taxes: You can borrow from your 401(k) without triggering penalties and taxes, as long as you observe the rules.
  • Keep control of capital structure: You avoid outside lenders and investors.

Cons

  • Required repayment: You must pay yourself interest and you must repay the loan within five years, or it will be considered a withdrawal subject to taxes and penalties. You can borrow up to half the money in the account, but no more than $50,000.
  • Risk retirement savings: Like the other methods, this method has the same risks to your retirement savings.

Other Financing Options to Consider

Here are some additional sources of funding in lieu of, or in conjunction with, 401(k) financing.

TypeDescriptionProsCons
SBA LoanLoan guaranteed by the Small Business Administration (SBA).SBA will guarantee loans up to 85% of pledged collateral at below market rates, with loans up to $5 million.Requires collateral. Restrictions apply to size of company and other factors.
Business LoanNon-SBA loans from banks, credit unions and commercial lenders (including peer-to-peer, or P2P).Banks and credit unions have the best rates. Commercial lenders might provide more access to loans than do banks and credit unions.Requires collateral. Banks and credit unions require good credit ratings and may take months to approve. Commercial lenders charge higher rates, although P2P might be more reasonable.
Personal LoanUnsecured loan from banks, credit unions and commercial lenders, including P2P.Does not require collateral.Average loan amounts of $50,000 or less. Banks and credit unions require a good personal credit score. Some commercial lenders are more lenient, but all charge higher interest rates.
Credit CardA personal or small business credit card, or a cash advance on a credit card.Fast access. Rewards and sign-up bonuses available.Amount limited by credit line. Need good personal credit to qualify for the best cards. High interest rate charged for an advance or carrying a balance.
Equity CrowdfundingYour business can sell stock or bonds to the general public on an online crowdfunding portal.You can raise up to $1 million per year.You will have to deal with investors. Portals require financial disclosure with the Securities and Exchange Commission (SEC).
Home Equity LoanA second mortgage or home equity line of credit.Can borrow on the equity in your home, usually at a low interest rate.Risk of foreclosure if you default on loan.

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