Tapping your 401(k) to start a business
Like many people these days, you may be thinking of starting your own business. You may be facing layoffs or uncertain job security at your present employer. Or your pay increases may be small or frozen altogether. Whatever the reasons you want to strike out on your own, there's one issue you will face like everyone else: how to finance your venture?
One source could be your 401(k). Let's take a look at the issues surrounding tapping into that source.
After spending years in
middle management, Rudy wanted to be his own boss. All he needed was some startup funds. A bank loan wasn't appealing because of the paperwork, and he didn't have sufficient equity for a home equity line of credit.
But he did have a 401(k) account. Why not tap into it to get his business rolling? Rudy met with his financial adviser to discuss the idea.
Barriers to hurdle
Rudy's adviser confirmed that, by taking out a 401(k) loan, he could sidestep arduous bank paperwork. Neither his credit score nor income level would matter. And Rudy would likely face a relatively low interest rate.
Yet before he could even get into the risks of the loan, his adviser warned, there might be some barriers to getting the money. First, did his employer allow 401(k) loans? Not all do.
Second, IRS rules generally limit borrowed amounts to $50,000 or 50 percent of the vested balance, whichever is less. Would this, combined with Rudy's savings, be enough to get his company off the ground?
Taxes and retirement
Assuming he could hurdle the barriers, Rudy would still face risks. After leaving his job, Rudy would have 60 days to repay the loan under his plan's rules. Others may vary. If he couldn't do so, it would become a distribution and count toward his adjusted gross income, driving up his tax liability. Because he was under age 59½, he'd incur a 10 pecent early withdrawal penalty, too.
Rudy's adviser noted that there might be a way around these tax risks if he could qualify for an arrangement commonly known as a Rollover as Business Startup. But the viability of ROBS is uncertain, so careful research would be required.
Getting back to risks, his adviser continued, Rudy's retirement savings would be in jeopardy if he couldn't pay back the 401(k) loan within the 60 days. His current balance would shrink, and he'd sacrifice compounding growth going forward. Once he left his job, he couldn't keep contributing to his existing 401(k) and might have more limited options for future retirement contributions.
On the other hand, assuming he has the cash flow, Rudy could set up a retirement plan under his new business. Depending on its structure, this plan might even allow him to save more than he could under his old 401(k).
A 401(k) loan for any purpose, Rudy's adviser concluded, is a risky endeavor. So whether for a prospective startup or any other goal, the projected tax and retirement impact must be weighed against the benefits and alternatives.
This has been a general discussion and is not intended to be specific advice to anyone. Situations vary, so you should seek the advice of a financial professional before taking any actions.
Norm Grill is a certified public accountant and managing partner of Grill & Partners LLC, accountants and consultants to closely held companies and high-net-worth individuals, with offices in Fairfield and Greenwich. He can be reached at n.grill@GRILL1.com.