One option for start-up capital for a new business is your 401(k). You can take a loan against your retirement savings with no penalty in order to start a business. You do have to repay the loan with interest, but since credit is still very, very tight and home equity is way down, tapping the retirement account is a viable way get a new business up and running.
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Entrepreneurs who have left their regular jobs to start a firm essentially have two options for using their 401(k)s as start-up capital. One is less complex than the other, but the more complex option can provide access to more money without fees.
The simple option is not all that different than a regular 401(k) loan.
Let’s say a lawyer or tax accountant plans a very small or single-person firm. He or she leaves a corporate job and takes the 401(k) savings from that company to the new business by establishing a 401(k) plan in that business’ name.
At that point, a traditional 401(k) loan can be taken from the new firm’s 401(k) plan. There are restrictions, though.
The entrepreneur can only borrow the lesser of 50% of savings, or $50,000. And the loan repayment plan typically lasts for five years and requires a fee of the prime interest rate plus 1% or 2%, says Robert Cheney, a financial planner at Westridge Wealth Strategies.
The small-business owner needs to have enough steady income to repay the loan. If payments can’t be made, the loan is considered in default, and taxes and an early-withdrawal penalty will apply if the 401(k) owner is not 591/2 or older.
The second, more complex option is often referred to as a ROBS loan — Rollovers as Business Start-ups, so-named by the IRS.
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.
The wording is not clear-cut in IRS rules, but the agency seems to require an independent appraisal of a business value to ensure tax compliance. But a start-up often has trouble meeting that goal because it may have zero value, Hauptman says.
That may be one reason why ROBS are mostly used by franchisees who are buying into an existing business.