You contribute to your retirement plan so that, one day down the road, you’ll be able to continue with a life “style”.
Although it’s not designed to be a rainy-day account, there are times that tapping into your 401(k) is necessary. And then there are times when utilizing your retirement funds is the prudent choice. For those looking to start a business, finding ready cash is key to a quick launch. Your retirement funds can offer you the funding, in a short time frame, making this a favorable option.
Is taking a loan from your 401(k) or IRA the best way to fund a business? Or are there better alternatives? For many entrepreneurs, a Rollover for Business Startups (ROBS) arrangement may provide the necessary resources, while minimizing debt and mitigating taxes. So, you are wondering, “What is the difference between a retirement plan loan and a ROBS arrangement?” Here is a closer look.
A 401(k) Business Loan
The IRS permits using 401(k)s and other qualified retirement accounts for loans, provided your retirement plan has a loan provision in place. The rule of 401(k) loans allows up to half of your vested balance or $50,000, (whichever is less), to be taken from the plan.
Taking a loan out of your 401(k) is no different from taking out a bank loan. You will be charged interest on the loan, but since you are lending to yourself, you are paying yourself back the principal and interest.
Here are some of the advantages and disadvantages of a 401(k)-business loan:
Pros
- If the loan is paid back, you avoid paying taxes or penalties on the loan.
- Interest rates are typically lower than for commercial loans and are easier to qualify for (there are no credit checks).
- Repayment is to yourself, not a third party.
- Defaulting on the loan will not affect your credit score.
Cons
- Your plan may limit the sources available for a loan.
- You may incur administrative and issuance fees in addition to the interest rate charges.
- Unless your plan specifies otherwise, you must repay the entire balance if you lose your job or quit while the loan is in repayment.
- You will no longer earn investment income on any monies withdrawn from your retirement account.
- If you are younger than 59.5, and you default on the loan, you will owe income taxes and a 10 percent early withdrawal penalty on the outstanding balance.
The ROBS Alternative
A Rollover for Business Startups can be used when establishing a new business, franchise or for your existing business. As seen in the recent post, ROBS: The Best-Kept Secret for Funding Your Dream Business, the approach is straightforward. After the creation of a C-Corporation, you will able to roll over your existing retirement funds into a newly established retirement account, after which the new company sells stock to the retirement plan. You then use the proceeds of that sale to finance the company’s operations.
Pros
- You pay no withdrawal penalties or taxes on money used for your business.
- There is no debt to pay back, either to a third party or yourself.
- You have more control over your retirement funds and how they are used.
- No credit check is required.
- With a retirement plan in place, you can continue to build wealth for your retirement.
- You can use the funds as a cash injection required for an SBA loan.
Cons
- You need to have terminated employment with the company that sponsors the retirement plan unless there is a provision for in-service withdrawals.
- You could lose a portion of your retirement savings if you do not reinvest to recoup what was transferred.
- You need to enlist the services of a knowledgeable plan services provider, in order to keep the plan in compliance with IRS/DOL regulations.
Benetrends has been helping small business owners launch their entrepreneurial dreams for decades. As a pioneers of 401(k)/IRA rollover funding, Benetrends helps entrepreneurs establish their businesses and create the retirement plans to drive business growth. To learn more about how Benetrends can help your entrepreneurial vision become a reality, schedule a consultation today.
