How to Fund Your Startup With a 401(k) Rollover
21 May 2020
You're our first priority. Every time.
We believe everyone should be able to make financial decisions with confidence. And while our site doesn’t feature every company or financial product available on the market, we’re proud that the guidance we offer, the information we provide and the tools we create are objective, independent, straightforward — and free.
So how do we make money? Our partners compensate us. This may influence which products we review and write about (and where those products appear on the site), but it in no way affects our recommendations or advice, which are grounded in thousands of hours of research. Bottom line? We’re on your side, even if it means we don’t make a cent.
After years of toiling for someone else’s profit, you might decide to launch your own startup business. And while bootstrapping is certainly an option, even a lean startup needs some capital and has expenses in the first year that may not be covered by initial revenues.
One way to fund your business startup is to leverage your 401(k). While putting your retirement on the line for your new company might seem like a huge risk, it’s actually not as risky as some business financing options. Of course, there are advantages and disadvantages to consider before making your final decision. Read on to find out how to get startup business funding with a 401(k) rollover.
What Is a 401(k) Rollover Startup Loan?
Known as Rollovers for Business Startups, this method of financing isn’t actually a loan. Instead, it’s a way to invest in your own company with your 401(k) funds.
Since this is more complex than other methods of funding, it is highly recommended that you work with an accountant or other professional if you decide to take this route. A small misstep could land you in deep tax bill territory, so it’s worth doing it right.
Business financing through a ROBS enables you to tap into your retirement account and use that money to start or buy a business without setting off an early withdrawal fee or penalty. Here’s a rundown of the steps you’ll need to take if you decide to go with this option.
- Create a new C corporation: 401(k) business financing is based on the sale of Qualified Employer Securities, and only a C corporation business type allows for the ability to sell stock within a ROBS structure.
- Establish a 401(k) plan for your C corporation: The 401(k) plan must be structured in such a way that it can hold stock in any asset or business held by the corporation. Once the plan type is selected, you’ll choose a custodian to manage the investments in the 401(k) plan.
- Roll existing funds into your new retirement plan: Once you have the foundation in place, you can roll your existing, personal 401(k) into the new retirement plan belonging to the C corporation. This rollover occurs all without paying any tax penalties, because you’re not withdrawing the money early.
- The retirement plan buys stock in C corporation: Now that you’ve established the new company’s retirement plan with money from the rollover, the retirement plan will purchase stock in your C corporation through QES transactions, which, again, is only permissible in C corporation business entities.
- Use the funds to run your business: Once the QES transaction has been completed, the corporation can use the retirement funds to operate the business and pay business expenditures. The retirement plan essentially owns the corporation with the business funding coming from the sale of QES stock.
Good To Know: How To Get a Business Loan
How Much Does It Cost To Fund Your Startup With a 401(k) Rollover?
The idea of using 401(k) money for funding often triggers fears of a big tax bill. However, the point here is that you’re not withdrawing the money early to spend. Instead, you’re simply using legal business structures to change what you invest your 401(k) in. Instead of mutual funds, for example, you’re investing in your own company.
However, this type of funding is not completely without cost. Since you’ll likely need some professional legal or accounting help, you may need to cover the costs of those services. When compared with the interest associated with traditional loans, that one-time expense can be very minimal.
Pros and Cons of Funding Your Business With ROBS
As with most things in finance, different methods of funding carry their own pros and cons. With funding a business through a ROBS, the case is no different. Here are some of the advantages and drawbacks to using a 401(k) rollover to finance your business.
Pros of Using ROBS to Fund Your Business
- You can save money. Many startups and small businesses are partially or completely funded by the owner’s own pockets. Using your 401(k) saves money because you’re investing pretax dollars. That’s not true, however, if you take money out of a savings account to fund your small business.
- You can use funds you likely don’t need right now. Depending on how far you are from retirement, the money you use to fund your business isn’t money you were expecting or needed to be available in the next few years to cover your own living expenses or needs.
- You can avoid the drawbacks of traditional lending. Another critical advantage is avoiding the use of traditional lending methods. With a ROBS, you don’t have to worry about repayment of principal and interest to a lender. And because there’s no application or use of credit, funding through this method doesn’t affect your credit like getting a business loan would.
Cons of Using ROBS to Fund Your Business
- You might not be able to rebuild your retirement funds quickly. One of the biggest disadvantages is that you are using your retirement funds to start the business. If your company isn’t as successful as planned, you might not be able to rebuild your retirement nest egg as quickly as you’d like.
- This type of funding might not be an option for you. Another disadvantage of funding your startup with a 401(k) rollover is that it’s not an available option for everyone who wants to launch a new company. You need to have enough in a 401(k) to make it worthwhile, which means this is typically an option for someone who has been working and saving for retirement for some time — or for people in former executive roles that come with high-paying 401(k) perks.
The Bottom Line
The truth is that your 401(k) is already being invested in businesses — usually, in publicly-traded companies as part of stocks and mutual funds. You can continue to invest in those companies — which you have no control over — or put your money where your dreams are and invest in your own startup.
Although pursuing business financing through a ROBS is not without risk, it’s surprisingly less risky than putting all your current cash into an endeavor. And it may be less risky for some entrepreneurs than an SBA loan.
More From Seek
- How To Safeguard Your Small Business For the Next Recession
- 10 Business Plan Tips for Your Startup
- 13 Entrepreneurs on the Moment They Made It
Photo credit: emilie zhang/Shutterstock.com