How To Borrow From 401k To Finance Your Business
There are many ways to use 401k funds to finance your business, but it involves a very complicated process and is not the same as just writing a check to yourself. There are important legal steps that need to be followed.
It is better to get the assistance of a financial planner, as this is not something you should attempt to do on your own. The third-party retirement plan administrator would set up a corporate retirement account. You can then roll over your retirement accounts in the corporate plan, and then invest the proceeds in the company’s stock.
This is not an easy thing to do and there are significant risks involved when plan to borrow from your 401k as venture capital to finance your business. There is a risk of losing not just your business, but all of your retirement savings along with it. Then there is a possibility of being penalized by the IRS.
Even so, there are many who use your 401k to finance their business. There are essentially three ways to do it – distribute the money, roll the money into a corporate retirement account and take a loan against the 401k. Let’s briefly look at each of the methods.
Method #1: Distribute Assets from your 401k
First, ask your 410k plan administrator to set up a distribution package. You will be given two options, a partial withdrawal or a complete withdrawal, depending on how much money you need.
The distributions are added to your annual gross income and any distribution before reaching the age of 59 years 6 months carry an automatic federal withholding of 20 percent as well as a 10 percent IRS penalty, apart from income taxes. You can now use the money to finance your business.
Method #2: Take a Loan
Ask your 401k plan administrator if your plan allows you to take a loan from the 401k. The IRS permits you to borrow up to 50 percent of your 401k or up to $50,000, tax free. This loan must be repaid within 5 years or upon the termination of the employment with interest. You can take more than one loan at a time. Consult with the financial expert and make sure that you get the loans at the lowest interest. Use the money to finance your business.
Method #3: Rollover into a Business Owner’s Retirement Savings Account
For this, you will need to get in touch with a CPA who handles the rollover of individual retirement accounts (IRA) into a business owner’s retirement savings account. The CPA sets up the account and becomes the plan administrator as well.
Open a new rollover IRA with a new administrator (your CPA) for this. Direct your 401k plan administrator to rollover the funds to the new IRA administrator. An automatic federal withholding of 20 percent will be charged on the indirect rollover. Fill out the paperwork so that the 401k assets are transferred to the rollover IRA.
Next, open a corporation and register it in the state that you reside in. Ask the CPA in charge of the rollover IRA to buy stock in the new corporation with the funds. The money is transferred to the operating accounts of the new corporation, and in return stock certificates are issued to the rollover IRA. The assets, which are now in the operating account, can be used to finance an existing business or buy a new one.
The Bottom Line
As you can see, using the 401k to fund a business is a complex process and an expensive one. Your financial advisor or CPA is likely to charge thousands of dollars to set up a plan for you. So this strategy would make sense only if you are investing a large chunk of your retirement savings into the business.