Looking for Ways to Fund Your Business?
If you’re just starting out with a small business, one of the first things you may look for will be money. For a lot of solo business owners, that money may come from their 401(k) plan. There are three main ways that this money may be accessed.
Option #1: Early withdrawal.
Early withdrawal from your 401(k) plan is the easiest, and also the most expensive plan. If you pull your money out too early, you will face an early withdrawal penalty of 10%, plus you will have to pay income tax on the amount you have drawn out.
We generally do not recommend that our clients use this option to access their 401(k) plan for investment in a small business.
Option #2: Loan.
If you’re still working for an employer and have an in-place 401(k) plan, you may be tempted to take out a loan. On the surface, this could seem like a good idea, because it allows you to access the funds without paying the penalty or taxes associated with an early withdrawal.
The problem is that most plans require you to pay back any outstanding loans if your employment terminates. So, if you get laid off, you have to pay the loan back. If your business takes off, you have to pay back the loan. You get the picture.
If you don’t have the cash readily available, it becomes an early withdrawal, and that means you have to pay penalty and interest. The only problem is that all the cash may now be invested, and you don’t have the extra money to pay the taxes.
Option #3: Sophisticated Roll-over
If you do an online search for roll-over 401(k) strategies, you’re likely to find a lot of information about rolling your 401(k) over into an IRA account. And then you can invest from there. Unfortunately, you won’t be able to take out loans for a new business, like you could from your 401(k) plan. That roll-over to an IRA strategy may work for you if you’re looking to do more passive investing. If your plan is to fund a business, you need a different strategy.
There is one sophisticated plan that may work for you. Do not try this without professional advice, because it is a more unusual and advanced strategy.
Step One: Form your new business as a C Corporation. A C Corporation is a specific type of business structure that files a tax return on its own behalf, and pays tax directly. It is a very different business structure from the more common S Corporation, or Limited Liability Company (LLC) used by most small businesses. For this reason alone, make sure you check in with your tax adviser to make sure it will work for you.
Step Two: Assuming you have the green light to form a C Corporation for your business, once it is done, you will need to establish a new 401(k) plan for this company. You’ll need a professional adviser helping you with this step as well.
Step Three: Once that is done, roll your old 401(k) plan (generally from a previous job) into this new 401(k) plan.
Step Four: You can now take a loan out of the new 401(k) plan and that money can be used to fund your new business.
You won’t pay income tax or penalties on this move, but there are a lot of steps and other things to consider.
Make sure the entity structure will work for you. Verify that the 401(k) rules for your new company allow you to take out a loan in the size that you need, and that you have interest and terms you can work with on the loan.
Your 401(k) plan can seem like a windfall for a new business. But there are steps you need to follow, and the wrong plan can cost you a lot of penalties and taxes. So move cautiously, and get good advice.