With the growing ranks of unemployed, there is an increase in people looking to finance new businesses using 401(k) retirement funds.
Many of these accidental entrepreneurs have not built up much savings beyond their retirement accounts, or if they did, may have depleted them once any severance ran out. And if they try to get bank financing they soon find out that without a job, they are not bankable.
There are two ways to tap into 401k's for funding for a new business: a traditional 401k loan or a Rollover as Business Start-up loan. Hardship 401k distributions should not be used to fund a new business.
The traditional loan is fairly simple, but not all 401k plans allow for loans. If they do, IRS rules place restrictions on such loans:
"Generally, if permitted by the plan, a participant may borrow up to 50% of his or her vested account balance up to a maximum of $50,000. The loan must be repaid within 5 years, unless the loan is used to buy the participant's main home. The loan repayments must be made in substantially level payments, at least quarterly, over the life of the loan."
Note that the dollar limit is a total cap on what can be borrowed, not a limit per loan.
Christine Dugas points out at an article at USAToday that there is another type of 401k loan for funding a business called a Rollover for Business Start-ups loan (also known as a "ROBS" loan by the IRS -- is this an editorial comment from the IRS about using your own money for funding a venture?):
"Entrepreneurs using this option typically need help from a firm specializing in such work.
"For a fee, these firms help the new business create its own 401(k) plan and transfer funds from the owner's existing 401(k). The retirement money is then used to purchase company stock that's held in the new 401(k) plan. This provides the entrepreneur's corporation with start-up capital.
"Some experts believe that it is harder for a new small business to meet IRS guidelines for ROBS loans."
Given that IRS regulations on ROBS are rather vague, I would STRONGLY caution against using this approach. Many of the 75,000+ pages of the IRS code come from court cases that were used to interpret other unclear tax legislation.
I usually shy away from any new tax laws that require IRS interpretation -- let others have their names placed on court cases that help sort out what was really meant by the new law. I had a hard time finding much information on the IRS website on this alternative, which is not a good sign.
"For these reasons, we intend to scrutinize ROBS arrangements. Our guidelines will serve as instructions to our technical specialists to resolve issues they encounter when evaluating these plans. We believe that ROBS arrangements may endanger the qualified status of otherwise tax-qualified employee plans and may be prohibited transactions, requiring complete undoing of the transaction, and imposition of excise taxes.
"In recent years, the IRS has taken steps to combat transactions that we believe are abusively tax avoidant. At the same time, we have noted an upswing in the number of these transactions that seek to exploit the generous tax benefits enjoyed by qualified retirement plans. While we are not ready to throw ROBS into this category, we are certainly mindful of the old adage that things that appear to be too good to be true usually are."
So even the IRS cautions about the ROBS loan option -- not a good sign!
If an "expert" tries to convince you to use a ROBS loan from your 401k, find another expert. This type of loan is at too much risk for IRS scrutiny -- your start-up will have enough risk without adding IRS problems to the mix.
To career entrepreneurs, using retirement money may not sound that risky. Most have always viewed their businesses as their retirement funding. But, these are folks who have gotten comfortable with that level of risk-taking. Make sure you think through what you will do next if the deal fails and your retirement is badly depleted.
Using a 401k to fund a business may be a reasonable risk. Make sure you have done your homework on the business before you draw down retirement to fund it. Develop a sound business model and develop a business plan. Once you do that, find some experienced people who will poke holes in your plans before you finally pull the trigger.
(Thanks to Ben Cunningham for suggesting this topic).
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