IRA Financial’s Adam Bergman discusses how you can use retirement funds to buy a business and why you should consider it.
In his latest podcast, Mr. Bergman talks about three different ways you can use retirement funds to buy a business. Essentially, you can take a taxable distribution, a loan from your 401(k) plan or utilize the ROBS structure. Further, he discusses the pros and cons of each method and whether or now you should consider it.
Why Use Retirement Funds to Buy a Business?
There are many reasons why you make look to your retirement funds to buy a business. Basically, it comes down to how much money you have on hand and if you want to borrow any shortfall. Obviously, funding and maintaining a business requires lots of capital. Even if you have the perfect plan, you can’t do much without cold hard cash.
Third party lenders (think banks) are usually the first place someone will look at for startup capital. First, you need to qualify for the loan in the first place. If and when you qualify, you’ll be looking at high interest rates to pay it back. Money that could help grow your business.
You may consider borrowing from a family member or close friend. You may also consider crowdfunding platforms. However, it’s probably not the best idea (if you have other options). In the end, starting a business is tough enough, but if you have other investors to think about, the pressure is ramped up.
That’s when you should look at your retirement savings. Very few people know that you can tap into your 401(k), IRA or other savings to fund your new business. In fact, it may be the best way!
Three Ways to Fund Your Business
The first way you can use retirement funds to buy a business is by taking a taxable distribution. If you have an IRA, you can withdraw funds from your plan at any time. Be warned, this comes with a price. First, you will pay taxes on the amount you withdraw. In the case of a Roth IRA, you may withdraw contributions tax-free, however, all earnings are taxable until you reach age 59 1/2. Prior to that age, all IRA distributions will be hit with a 10% early withdrawal penalty. While this is an option, it’s generally one that should be used as a last resort.
If you have a 401(k) plan, you need a triggering event to distribute money from the plan. The two most common ones are reaching retirement age (59 1/2) or separating employment from the company that holds the plan. If you leave your job to start you new business, you may withdraw the funds. Like an IRA, taxes and penalties (if applicable) will be due.
Let’s preface this by saying you cannot take a loan with an IRA. It’s simple not allowed by the IRS. However, so long as your plan allows for it, a 401(k) loan is a good option to buy a business. Like any other loan, you have to repay the loan on a schedule and pay interest on the amount borrowed. You are limited to borrowing half the 401(k) account balance, up to $50,000. If you have $10 million or $100,000, you can take the same amount. If you have less than $100,000, divide your total by two, and that’s the amount you can take out.
First and foremost, your plan provider must allow for the loan. You must also keep in mind, that like a withdrawal, any funds taken from the plan will no longer be earning money for you. That’s the biggest drawback to dipping into your retirement funds to buy a business. Further, you must keep up your payments. They are required to made at least quarterly. Failure to do so will lead to the remaining balance being treated like a distribution.
Lastly, of course, is the interest. Unlike when you take a loan out from a bank, the interest gets paid back into the plan. Rates are usually lower – Prime Rate (which sits at 4.75%) plus one percent. Paying the interest back to yourself is an added bonus. Of course, if the amount you can withdraw is insufficient, you will need to find funding elsewhere.
Rollover as Business Startups
Last, but not least, is the ROBS solution. According to Mr. Bergman, it’s the best way to use retirement funds to buy a business. Essentially, you can take as much as you want from your retirement account to invest in a new business. Alternatively, you can use the funds to improve an existing business. ROBS is IRS-approved, however it come with heavy scrutiny. When deciding to enter into the structure, it;s best to work with experienced professionals.
Here are a few things to consider when using ROBS for your business –
- You must use a C Corporation as your business entity. You cannot use an LLC or other type of business.
- A 401(k) plan is created which buys stock in the business – known as qualifying employer securities.
- The 401(k) is funded with your own retirement savings (hence the “rollover” part).
- You then must receive a salary based on the work or services you perform.
ROBS is so beneficial to use since there is no taxable distribution, no loans to pay back and it’s tax advantageous. This allows you to diversify yourself, but be warned, half of all businesses fail within five years! It’s important that you don’t use all of your savings in your business venture. If the unthinkable happens and your business fails, retirement may never come for you!
Using Retirement Funds to Buy a Business – Final Thoughts
If you are thinking about starting your own business, look no further than your retirement savings to get it going. Several factors go into this decision, including how much you have saved, your age and tax implications. It’s important to work with a financial advisor to ensure you know what you’re getting into. It’s all essential to work with a provider, such as IRA Financial, if you plan on using the ROBS structure.
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