Using a 401(k) to Start a Business: 401(k) Business Financing

We don’t have to tell you that financing your business is one of the biggest challenges of entrepreneurship, whether you’re just starting out or looking to grow or buy an existing company. Although business loans work for many entrepreneurs, you might not like the idea of taking on debt, especially if you have funds of your own that you can bring to the business. In this case, however, the problem is that most people have personal savings tied up in investments or retirement accounts like 401(k)s and individual retirement accounts (IRAs).

If you have one of these retirement accounts, you might then be wondering how to use your 401(k) to start a business. Fortunately, there are ways to take cash out of a retirement account and invest the money in your business, though there is substantial risk involved.

To help you sort through the maze of using a 401(k) to start a business, we’ve created this guide. We’ll break down your top three options for 401(k) business financing—including who’s eligible, how they work, and the pros and cons of using them. We’ll also explore some of your best alternative funding options and finally, discuss whether or not you should use a 401(k) to start a business.

If you’re thinking about using a 401(k) to start a business, there are a few points you’ll want to keep in mind before you explore your different financing options.

To begin, you’ll want to remember that ordinarily, if you withdraw money out of a 401(k) or IRA before the age of 59 ½, you have to pay income taxes on the money, plus a 10% early withdrawal penalty. Therefore, if you’re wondering how to use your 401(k) to start a business, you’re taking on a considerable amount of risk in doing so.

Luckily, however, short of simply withdrawing money from your retirement account, there are two better options that allow you to tap into your retirement funds without having to pay income taxes or penalties. First, you can take out a 401(k) loan to finance your business—or, second, you can rollover your balance into a new 401(k), called ROBS, or rollovers as business startups.

In both of these cases, although you won’t face the same taxes and penalties as taking directly from your account, there will nevertheless be inherent risk involved—you’ll risk losing your retirement savings if your business doesn’t do well. Ultimately, whether or not you decide on using a 401(k) to start a business will depend on your personal level of risk tolerance and what you think is best for your future.

All of this being said, if you believe the risk is worth taking, the money in your retirement account could be the ticket to starting or growing your business. Therefore, let’s take an in-depth look at your three different options for using a 401(k) to start a business, so you can determine if any of these solutions is right for you.

If you’re looking into using a 401(k) to start a business—or finance an existing one—you might consider getting a 401(k) business loan, especially if you need less than $50,000 in financing and plan to stay employed for the time being. What is a 401(k) loan?

If your 401(k) or other eligible retirement plan allows loans, then the IRS permits you to borrow up to half of your vested balance, or $50,000—whichever is less. This amount you borrow, therefore, is your 401(k) loan, which can be used for any eligible purpose, including business purposes. With this loan, you will be charged interest, however, since you’re borrowing from your retirement plan, you’re actually paying the principal and interest back to yourself.

The key with this type of 401(k) business financing, though, is that you have to remain employed and enrolled in your employer-sponsored retirement plan while the loan is outstanding. If you lose your job or decide to leave, you’ll have to pay back the full loan within two months. This being said, for most entrepreneurs, a 401(k) loan isn’t practical unless they’re considering starting a business as a side gig for a while. In fact, most people use 401(k) loans not for business, but for personal expenses, such as medical bills or home renovation costs.

When you’re considering using a 401(k) loan to start a business, you’ll want to keep in mind that only some retirement plans allow you to take loans, including profit-sharing plans and 401(k), 403(b), and 457(b) plans. You can’t take a loan from an IRA, except for something called a 60-day rollover, which would function like a very short-term business loan.

Therefore, before you decide to use a 401(k) loan, you’ll want to check with your plan administrator—some plans don’t allow loans, and others restrict what borrowed funds can be used for. For example, your employer might specifically prohibit funds from being used to start a competing business.

With a 401(k) loan, the IRS has rules around how much money you can borrow from your retirement plan in any given year. You can borrow the lesser amount of:

• $50,000; or
• Half of your vested balance.

As an example, then, let’s say you have $80,000 in your 401(k) account. The maximum you can borrow in a calendar year is half of that balance—$40,000. Let’s say you borrow $10,000 from your 401(k) in January of the calendar year. After that, you find that you need more money in July. In July, you can borrow a maximum of $30,000.

In most cases, the interest rate on a 401(k) business loan or other retirement plan loan is 1% plus the prime rate. The time to pay back this loan is usually 5 years, on par with a medium-term loan. Additionally, there might also be modest issuance or administration fees associated with a 401(k) loan, but these go to the provider (not back into your own account). The specific details of your loan will vary based on your plan administrator’s rules.

This being said, the largest “cost” of a 401(k) loan is the lost opportunity from borrowing the funds, instead of keeping them in your retirement account.^[1] For instance, say the average return on your retirement account is 10% but the interest rate on your plan loan (that you’re paying yourself) is 6%. This 4% difference can easily add up to thousands of dollars over time that you’re losing by borrowing from your retirement savings. If, however, you believe that your business profits will counteract that loss, then the loan might be worthwhile.

Moreover, there’s another important qualification of a 401(k) loan to keep in mind: If you’re using an employer-sponsored retirement plan and lose your job (or decide to leave voluntarily), the entire balance plus interest is due within 60 days. If you can’t pay back the money you borrowed in this very short period of time, the loan goes into default.

In an ideal world, you would borrow money from your retirement plan, see your business grow, and comfortably be able to pay back the money with interest within the five-year deadline. But things don’t always work out as planned— your company’s cash flow might not be as strong as you hoped, or personal financial emergencies might come up.

If you miss multiple installment payments or are unable to pay back the loan within the time frame set out in your plan documents, the loan goes into default.^[2] In this case, the IRS will treat the money you took out as a withdrawal—meaning that if you’re under 59 ½ years of age, you’ll have to pay income taxes on the money plus a 10% early withdrawal penalty.

There’s one piece of good news, however—even if you default on the loan, the plan administrator can’t report this default to the credit bureaus. Therefore, unlike a defaulted mortgage or student loan, which will impact your credit score, your default on a 401(k) loan shouldn’t hurt your ability to get financing down the line.

As you’ve seen through our discussion, using a 401(k) to start a business in this way has multiple advantages and disadvantages. Here’s what to consider as you’re thinking about a 401(k) loan:

With both pros and cons to this 401(k) business financing option, you might also consider this experience from Jeff Hensel, owner of the private mortgage lender North Coast Financial, who used a 401(k) loan to start his company. He said:

I took out a 401k loan and will definitely use this option again in the future if I have to. The best part is that the interest paid on the 401k loan is paid to yourself (the money goes back into your 401k account). If $50,000 or less is needed, this is an excellent option for borrowing funds. I found 401k loans to be much more cost effective than credit cards, private money loans, or lines of credit. The only downside was the $50,000 loan limitation.

Ultimately, then, as Hensel mentions, using a 401(k) to start a business by taking out a 401(k) loan is best for entrepreneurs who need less than $50,000 in financing and who will remain employed while they’re starting their business. If you’re interested in funding your business with a 401(k) loan, you can get started by contacting your plan administrator. The timeline for a retirement plan loan ranges from one day to several weeks, depending on the application process outlined in your plan documents.

The second option you have for using a 401(k) to start a business is called ROBS, which, as we mentioned earlier, stands for rollovers as business startups. ROBS gives you another way to access retirement funds from a 401(k), IRA, or another eligible retirement account without having to pay income taxes and early withdrawal penalties.

Compared to a 401(k) loan, a ROBS offers more flexibility for entrepreneurs because there’s no obligation that you have to remain employed in order to use this financing option. In fact, with a ROBS, you cannot use a retirement account from a current employer. This being said, however, doing a ROBS is also more complicated than taking a loan from your retirement plan.

To explain, with a ROBS, you first have to structure your business as a C-corporation. Then, you have to set up a new retirement plan under the C-corp. At that point, you can rollover the funds from your existing retirement plan into the new company’s retirement plan. Finally, your new corporation sells stock to the retirement plan, and the company uses the proceeds from the sale as a source of capital—with one catch—you can’t pay owners’ salaries from these funds.

In order to utilize this type of 401(k) business financing, you must meet four main eligibility requirements:

• You need an eligible retirement account—such as a 401(k), 403(b), SEP, Keogh, or traditional IRA. Roth accounts are not eligible.
• The retirement account must have at least $50,000.
• The business owner should be an employee of the business and receive a salary.
• You must either have a C-corp or be willing to structure your business as a C-corp.

If you meet these requirements, you can get started with a ROBS. Although you can set up a ROBS on your own, there are a lot of IRS regulations and legal rules, so we’d recommend hiring a professional like Guidant or Benetrends.

ROBS providers charge a one-time, upfront fee and an ongoing administration fee. The one-time fee, which typically comes to around $5,000, covers C-corp and retirement plan setup and issuing the stock certificates. The ongoing administration fee, which is approximately $100 to $150 per month, ensures that you’re in compliance with any rules around retirement plan administration. If you use a professional service to help you set up a ROBS, you’ll then pay any associated fees for their assistance throughout the process.

One of the major differences between a 401(k) loan and a ROBS is the amount of money you can use. With a 401(k) loan, $50,000 is the maximum you can borrow. With a ROBS, on the other hand, $50,000 is the minimum you have to take out of your retirement account. Therefore, your choice between these two 401(k) business financing options will largely depend on the amount of money that you have in your retirement account and the percentage that you’re willing to put toward your business.

All of this being said, however, one of the biggest and most important differences between a retirement plan loan and a ROBS is that a ROBS isn’t a loan. The appeal of a ROBS, then, is that by using one you won’t have any debt to pay back—not to yourself and not to a third party.

However, just as is the case with 401(k) loans, using a ROBS poses the risk of losing retirement funds. If you roll over money into your business and the business doesn’t do well, you could lose your retirement savings. Plus, since there’s no ceiling on the amount of money you can use with a ROBS, that actually creates greater risk. If your business doesn’t do well, you could potentially lose all of your retirement savings, not just a subset.

Moreover, there are other disadvantages that are unique to a ROBS: Setting up a C-corp and a new retirement plan isn’t simple, you need to comply with numerous legal rules to avoid hefty tax penalties, and there’s a slightly elevated risk of an IRS audit when you do a ROBS.

All of this being said, just like with 401(k) loans, there are advantages and disadvantages to using a 401(k) to start a business by utilizing a ROBS. Let’s break down the pros and cons:

With all of this information in mind, you might also consider the experience of  Suzie and Todd Ford, co-owners of NoDa Brewing Company, who used a ROBS to start their business. They said:

We rolled our 401(k) plan into our company’s 401(k) plan that was created through the ROBS process. The full process took a couple months. Guidant directed us and made things easy along the way. A friend of ours is a CPA, and she’s actually the one who recommended it.  One of her clients used it to start his business, and was pleased. We have a monthly maintenance fee which includes unlimited monthly calls, questions, and inquiries from me, plus annual reporting. We recommend using ROBS as long as you positively understand the risks and that if your business fails, you more than likely will lose all your 401(k) funds.

As the Fords have noted, the biggest problem with a ROBS—which also can be a problem with a 401(k) loan—is that if your business fails, you could lose both your company and part (or all) of your retirement savings. Compared directly to a 401(k) loan, however, a ROBS is going to be a better option for business owners who need $50,000 or more in financing and who want to devote themselves to their business full-time.

If you’re thinking about using a 401(k) to start a business, you have one last option to consider: You can take a cash distribution from your retirement account. As we’ve mentioned, however, this is definitely not your best option for business financing—unless you’re over the age of 59 ½, you’ll have to pay income taxes on the distribution, as well as pay a 10% early withdrawal penalty.^[3]

For this reason, we wouldn’t recommend this as a 401(k) business financing option unless you’ve completely exhausted all of your other possibilities. After all, since you’re withdrawing directly from your retirement account, you’ll not only be facing the associated taxes and penalties, but you’ll also be losing any potential earnings on those funds—seriously impacting your retirement planning. Plus, even if you think that you’ll be able to make up those funds through the money generated by your business, in the case that your business does fail, you’ll be left without any retirement savings.

If you are willing to risk your retirement funds by using a 401(k) to start a business, however, utilizing a 401(k) loan or a ROBS at least lets you avoid the income tax and early withdrawal penalties from taking a direct distribution.

All of this being said, if you were to take a distribution from your retirement account, you could work with your provider to go through the process, however, you would face the respective taxes, penalties, and fees, along the way.

Ultimately, the only benefits of this 401(k) business financing option are that—first, you’ll eventually have capital on hand—and second, you’ll have the freedom to use these funds as you see fit. In the end, though, as we’ve discussed, the drawbacks of this course of action are much more significant.

Now that we’ve explored the details regarding these three different ways of using a 401(k) to start a business, you can see that each option has a certain degree of risk. Because of this risk, we’d recommend exploring all of your other business funding options before you decide to dip into your 401(k) to finance your business.

What are the best alternatives to 401(k) business financing? The answer to this question will be different for every business owner, however, there are two financing sources that will generally be your best bet when it comes to finding a less risky source of funding. Let’s break down these options:

You might be thinking about using a 401(k) to start a business because you have bad credit or you’re concerned that you won’t be able to qualify for a business loan. Or, perhaps you walked into your local bank, they denied your loan application, and you’re thinking 401(k) financing is your only option. This might not necessarily be the case.

Even if your business is just starting out or if your personal credit isn’t ideal, there’s likely still a business loan option that you can qualify for. From secured business loan options—like invoice financing and equipment financing—to short-term options—like a short-term online loan or a business line of credit—business loans come in all different shapes and sizes, some of which are surprisingly accessible to business owners. In fact, there are even business startup loans with no credit check for entrepreneurs just starting out who have low credit scores.

At the end of the day, with all of the business loan possibilities that are available, you’ll want to thoroughly explore all of your options before using a 401(k) to start a business.

Many people who consider using 401(k) business financing only need a small amount of money. In fact, according to the National Bureau of Economic Research, the average 401(k) loan is just around $10,000.^[4] This being said, if your funding needs aren’t too high, business credit cards might be an easier and more cost-effective solution for you. Business credit cards rely on your personal credit—so the higher your credit is, the better the card you’ll be able to qualify for. There are, however, business credit card options for different score ranges.

As a financing option, business credit cards can be beneficial for both new and established businesses. Many cards offer a 0% intro APR period—meaning for several months after you open your account, you don’t have to pay any interest on expenses. As long as you make your monthly minimum payment on time every month, you’ll be able to carry an interest-free balance from month-to-month during a 0% intro APR period. Essentially, then, your business credit card works like a free loan during the zero-interest period.

If you think a 0% intro APR credit card might be a good alternative to using a 401(k) to start a business, then we’d suggest you look into the American Express Blue Business Plus card. This business credit card offers a 12-month 0% intro APR period. Plus, as you spend, you’ll earn rewards points at 2x for the first $50,000 you spend every year. After 12 months, a variable APR sets in at a rate depending on your creditworthiness and the market Prime Rate.

At the end of the day, it’s up to you to decide what the best financing option is to start or continue your business. This being said, though, considering everything we’ve discussed, we’d suggest alternative financing before using a 401(k) to start a business—business loans and credit cards work well for many entrepreneurs.

If you’ve exhausted all of your options, however, and you are thinking about how to use your 401(k) to start a business, we’d recommend you keep these summarized points in mind:

• 401(k) loans allow you to take a loan from your own retirement account. You pay yourself back the principal and interest, typically over a five-year period.
• ROBS is a more complicated option for larger financing needs. You create a C-corp and a new retirement plan and roll funds over from your old retirement plan into your new one.
• Outside of a 401(k) loan or ROBS, we wouldn’t suggest taking an early distribution from your retirement account. You’ll end up having to pay income taxes and an early withdrawal penalty.

Once again, using a 401(k) to start a business boils down to your personal risk tolerance. If you have a really strong business plan and think that your business could grow quickly, then using retirement funds could be worth the risk. You’ll always want to have a backup plan, however, just in case everything doesn’t work out as you expected—after all, planning ahead is the best way to succeed as a business owner.

1. Investopedia.com. “4 Reasons to Borrow from Your 401(k)“
2. HRDailyAdvisor.BLR.com. “IRS: Missed 401(k) Loan Repayments Can Be Made Up Without Being Taxed“
3. IRS.gov. “401(k) Resource Guide – Plan Participants – General Distribution Rules“
4. NBER.org. “Borrowing from 401(k)s“