Of all the ways you can bootstrap your startup business into existence, the very last one you should consider is digging into your 401(k) or other tax-favored retirement plan. There are good reasons why government tax penalties are so stiff on such withdrawals.
First, drain every other financial asset you own. Beg, plead and borrow from family and friends. Rack up credit-card debt to the stratosphere. Then and only then, if you’ve exhausted every creative business financing option available and you still need funds, consider the one way that you can access your 401(k) both legally and safely: borrow from it. But there are stringent laws covering repayment and how it must be done. If you don’t follow them, you can easily lose enough of your retirement savings to force you to work for the rest of your life.
Beware the negatives of simply withdrawing funds
The one thing you don’t want to do unless it’s your last resort (many financial planners say it should never be done, whatever the circumstances) is just withdraw money straightaway from your 401(k) account. Whatever you take out of your 401(k) is subject to regular income taxes, and if you’re younger than 59-1/2 you’ll fork over an additional 10 percent tax penalty.
“Using those assets is a pretty risky proposition because you’re taking away from your safety net for retirement,” says Tim Swartley, a trust officer at Univest, a bank-holding company based in Souderton, Pa. “All the benefits you’ve accrued by saving pre-tax dollars and tax-deferred compounding over the years – maybe over a lifetime of employment -- go away if you tap these funds. Of course, very often when you talk about an entrepreneur, you’re talking about a risk taker.”
Just remember, what you’re risking is any reasonable chance to retire.
Still have to have it? Take a personal loan from your 401(k)
Instead of withdrawing funds outright, you could take a loan from your retirement plan as a way of getting some startup capital and business financing. There are two ways of doing this.
One is to take a personal loan from your 401(k) plan. Under this approach, you’ll need to incorporate your business and then buy all of the stock in it with a loan from the plan. Typically, you’ll also need to roll over your remaining 401(k) assets from your previous employer’s plan into a new 401(k) plan with your startup business; most companies won’t administer the assets of a 401(k) plan for former employees.
While this is the simpler of the two approaches, there are some significant drawbacks. Most typically, your loan is limited by law to 50 percent of the vested balance in your retirement plan or $50,000 – whichever is less. And all of it must be repaid to your 401(k) plan within five years, amortized quarterly. In other words, you can’t wait until the end of the five-year period to pay it back all at once. You have to make quarterly payments. And that alone still leaves your nest egg at risk. You should also continue to make your customary contributions to the 401(k).
For this type of loan, a typical interest rate would be the bank’s prime lending rate – that which it charges its best corporate customers – plus maybe 1 percent. The good news is that you’re paying this interest rate to yourself by paying it back into your 401(k). The bad news is that, had you left your nest egg untouched, it would likely have been earning far more interest during the five years it will take you to pay it back.
Make a business loan from your 401(k) to your startup business
This second approach is the best way to tap into your retirement plan if you absolutely must do it, financial advisors say. “The law specifically permits people to use IRAs and 401(k)s to invest in a business with no taxes, no penalties and no need for loan repayments,” says Leonard Fischer, CEO of BeneTrends, a company that has developed a system for doing so. “What we do is purely add another investment option in your retirement plan. You invest in your own company.”
The cheaper but riskier way is to ask a conventional investment outfit, such as a mutual fund company, to set up the documentation for you. “Many of them will do it because they’re interested in getting the assets,” says Susan Daley, attorney for Perkins Coie, a Chicago law firm that specializes in employee benefits and executive compensation.
But both Daley and Fischer note that this type of plan is complex. Fischer says you should have at least $30,000 in your retirement account to justify the costs of setting up a BeneTrends plan, for which he’ll charge you as much as $4,500, including a thorough third-party valuation of your small business.
Another wrinkle with this approach is that you should make just one loan to your business from your 401(k) plan, because any time you do it, you’re required to get and pay for another costly third-party evaluation of your business. And, Daley explains, “you should really only do something like this if you’re the only employee of the company. Once you have (other) employees, you have to offer shares in the company to all of them” under the same terms by which your retirement plan bought stock in your company.
Use your retirement plan as a backup
Even if you don’t touch your 401(k) funds, they can still have benefits beyond providing retirement income. One of them is the fact that bank officers will count them as part of your household net worth in determining whether you and your startup business are loan-worthy.
And for C. David Gammel, who launched High Context, a Web-consulting business in Silver Spring, Md., in 2005, 12 years of 401(k) contributions he made while in the corporate work force “made it possible for me to feel comfortable taking the risk of starting my own business without having to actually cash them in and taking the tax hit and penalties.”
Our Bottom Line
Tapping into retirement funds as a creative means of financing your startup business is never a good idea. If you have nowhere else to turn, at least take the time to ask for the advice and counsel of a certified financial planner. Although it will cost, scrimping there could be penny wise but…you know the rest.