Getting a bank loan isn’t easy for any small business—but when you’re starting up, it’s especially challenging. Without a track record of success on your side, most banks will be leery of taking a chance on your business. Thanks to your diligent retirement savings, however, you may have tens of thousands of dollars available to use for starting your business. Should you use those retirement funds for startup capital? That is the important question.
There are a two ways you can use retirement funds to finance your new business. Let’s start with the easier method:
1. Take Out a Loan From Your Retirement Plan
If you have a 401(k) plan through your employer, you have the option to borrow money from your plan. You can borrow $50,000, or up to 50% of the amount in your retirement account, whichever is less.
One big advantage is that you won’t owe money to a third party. Instead, you just pay the loan back to your own retirement account. There’s also no income tax or early withdrawal penalty on the amount you borrow from your retirement plan.
The major disadvantage is that by taking money out of your retirement account, you’re decreasing your account’s power to earn interest. Speaking of interest, you’ll still have to pay interest on the loan you take out, and you’ll have loan payments right away. On top of normal startup costs, the added burden of another loan could be tough for a new business to swing.
Make sure the plan allows loans to be used for business startups since some plans do not. If your 401(k) doesn’t allow for a loan to be used for business purposes, here’s another method, albeit a more complicated one.
2. Use Rollovers as Business Startups (ROBS)
Rollovers as Business Startups (ROBS) is a type of retirement fund financing that is much more involved than simply taking out a loan. Here’s how it works: You structure your business as a C-corporation, start a retirement plan sponsored by your business that allows plan participants to buy stock in your company, and roll over your existing retirement fund into that plan. You then use your retirement funds to buy company stock—putting money into your new company’s bank account.
Since the ROBS method involves the purchase of equity, as opposed to the issuance of debt, there are no loan payments to make. And unlike borrowing from your 401(k), there is no limit to how much money you can put into your startup using the ROBS method.
That being said, ROBS can be tricky, so much so that failing to comply with IRS guidelines for ROBS could open you up to an audit. If you choose to pursue a ROBS strategy, be sure you follow all applicable regulations. In addition to the complexity and cost of setting up the ROBS, you’ll also need to maintain your qualified retirement plan and extend it to all of your employees—which means additional time, expense and record keeping.
So, Should You? Or Shouldn’t You?
Before deciding which method to use, you need to decide if using your retirement fund is a good idea in the first place. Ask yourself these four questions:
1. How Close to Retirement Age Are You?
The younger you are, the less risk there is in using your retirement fund for startup capital. Even if your business fails, you have time to rebuild your retirement fund back up again. On the other hand, if you’re in your 50s, borrowing from your retirement plan is much riskier, since you have less time to rebuild your nest egg.
2. What Type of Safety Net Do You Have?
In addition to your own retirement funds, consider other sources of income available to you in retirement. For example, if you are 58, still working, married and your spouse has a hefty retirement fund as well, tapping into some of your own retirement fund may not pose a huge risk. On the other hand, if you are 58, single, recently laid off and have no family members, you may want to hold on to your retirement fund.
3. How Much Money Is in Your Retirement Fund?
If you haven’t been contributing to your retirement plan for long, you may not have enough money available in the fund to make this a viable financing option.
4. How Risky Is Your Startup?
It’s natural to believe in your new business, but it’s also important to be realistic. Before using your retirement fund to launch your business, make sure you have a solid business plan, detailed financial projections and a proven business model. According to Guidant Financial, one-third of ROBS are used to finance the purchase of a franchise or existing company. This makes sense, because franchises and existing businesses have proven systems in place.
Whatever your situation, using your retirement fund to finance your startup isn’t a decision to make lightly. Think it through carefully before tapping into your future.