The Pros & Cons of Using Your Nest Egg to Fund Your Business
If you need funding to start a small business, you may be able to avoid taking on business debt by using your retirement savings.
If you’ve been in the workforce for some time and are considering leaving your 9-to-5 for an entrepreneur’s life, you may be able to avoid taking on business debt by using your retirement savings to fund your business.
But is leveraging your nest egg to finance your new venture really a good idea? Before we get into the pros and cons of this option, let’s start with a clearer understanding of exactly how the retirement-based funding process works.
How to Fund a Business With Your IRA or 401(k)
Depending on the type of retirement account you hold, your specific tax considerations, and your personal goals, there are a few different ways that you can go about using retirement accounts to fund your business. Let’s take a look at the three most common scenarios:
The Taxable Distribution
If your savings are held in an individual retirement account (IRA), you have the option of taking the funds at any time as a taxable distribution. Doing so would be costly, however, since taking a distribution from a pre-tax IRA triggers both ordinary income tax on the funds removed and a 10% early distribution penalty for individuals under the age of 59-and-a-half.
With a Roth (after-tax) IRA, there’s no ordinary income tax on the distribution, but for those under 59-and-a-half, the 10% early distribution penalty still applies.
In either case, taking an early retirement distribution to fund your business is probably going to cost you some tax dollars. But if your business only needs a limited amount of funding—or if you’re starting your business at age 60 or older—you might find a distribution to be your best option.
The 401(k) Loan Option
Provided your 401(k) retirement plan includes a loan feature, you may be eligible to borrow up to 50% of your account value—up to a maximum of $50,000. While the loan must be repaid within five years and is subject to the prime interest rate at the time it is taken out, taking out a 401(k) loan does offer you tax-free and penalty-free access to your retirement funds for the purpose of financing your business.
The ROBS Option
A complex and somewhat controversial financing option, the Rollover Business Startup Solution (ROBS) allows for the tax-free “rollover” of retirement funds to fund a corporation. Using ROBS to fund your business involves some rather complex steps, but here’s a basic rundown of how it works:
- First, you would open a C-Corporation for your business, as this is the only allowable business structure for use of the ROBS arrangement.
- From there, you would need to establish a new 401(k) plan sponsored by your C-Corporation, then roll over your previously existing pre-tax IRA or 401(k) plan into the new 401(k) account.
- Then your newly sponsored 401(k) plan would have the option to buy stock in your corporation, thereby making the funds available for business use.
Should You Use Your Nest Egg to Fund Your Business?
Now you understand how funding your business with your retirement account would work. But is it actually the best startup funding choice for your particular circumstances? Consider these pros and cons to help you decide:
PRO: Easy Access to Debt-Free Funding
Nobody likes the idea of taking on debt for a new business venture and, depending on your credit situation, affordable business financing can be hard to come by. Using a retirement fund to launch your business lets you bypass the lenders, giving you more personal control over your financial future.
CON: Complex Setup May Require Professional Help
Particularly if you choose the ROBS arrangement to avoid extra taxes or penalties, you will most likely need outside assistance to correctly set up your accounts and fund your business in accordance with the law. Many financial firms can assist with such a setup, but their services will make a significant cut into your business’s bottom line.
PRO: Tax Protection for Your Retirement Funds
While the complexity of ROBS may be a disadvantage, one benefit of the arrangement is the ability to avoid being taxed on your retirement cash. Particularly if you’re under 59-and-a-half and you have a pre-tax IRA account, those taxes can add up quickly, but ROBS allows you to bypass those costs completely.
CON: May Invite Increased Attention from the IRS
Although the IRS has technically approved these methods of retirement-based funding as legal, financing your business in this way is still a deviation from normal practices that will invite extra tax scrutiny. If you choose ROBS to fund your business, you could get audited. For this reason, it’s even more important that you make sure every piece of your personal and business finances—both related to your retirement accounts and otherwise—is completely above board.
Bottom Line: Understand That You’re Taking a Risk
No matter how you decide to go about funding, starting a new business is always a risk. If you invest your nest egg into a business venture that doesn’t work out, you risk losing the savings that you’ve spent your life accumulating. Then again, if you take out a small business loan and your business goes under, you most likely would still be personally liable for that debt. There’s risk involved either way, so it’s up to you whether involving your retirement funds will be the right choice.
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