One of the biggest challenges in buying a business is financing. If an opportunity presents itself but you don't want to ask family or banks for loans, you might consider using your retirement account instead.

You may be wondering whether it’s possible to use your 401k account to invest, how to do it, and what the consequences are for tapping into these funds.

In this article, I’ll address all of these points and provide alternative methods to consider so that you can make the best decision for your financial future. 

Key Takeaways

• Rolling over funds (ROBS) or using a 401k loan are the best methods to buy a business using your 401k to avoid taxes and withdrawal fees.

  
  

• If you are younger than 59 and a half years old, you will face a 10% early withdrawal penalty for using money in your 401k and be charged income tax on the cash. 

  
  

• Other financing alternatives besides your 401k are personal loans, credit card loans, loans from friends and family, or SBA loans.

Is it Possible to Use Your 401k to Buy a Business?

It is possible to use your 401k to buy a business; however, to use these funds legally and avoid penalties, there are some factors you must keep in mind. 

The main factors to consider are:

• The amount you need for your investment. For a 401k loan, the IRS only allows you to withdraw half or $50,000 from your account, whichever option is lesser.  

  
  

• Your 401k plan and the program it operates in. Your employer and loan plan will determine your payback period and interest rates should you choose a 401k loan. They may also set specific limits and rules on your access to your account.

  
  

• The risk of losing your retirement savings. Even if you have enough in your account, you don’t want to withdraw too much, as you might need the funds for your retirement. If your business fails, then you may not have enough money left to fund your retirement so it’s important to be aware of the consequences.

Lastly, there are multiple methods to consider for using your 401k to buy a business, each with its own pros and cons so it’s important to assess which method (if any) is right for you. 

Methods to Use Your 401k to Buy a Business

You have a few options to access your 401k account to buy a business, but it’s worth noting that you should always speak with your 401k plan administrator before making any big decisions. They can give you the details of how to take out a loan and the loan terms.

That said, the most common methods include:

Rollover for Business Startups (ROBS)

The first option is to use a rollover to fund your business venture. ROBS allows you to use the money in your 401k while avoiding taxes and withdrawal penalties. To use a ROBS, you must find a ROBS provider to guide you through the process.

There are several requirements to use a ROBS to buy a business. 

• You have $50,000 in your account 

• You work full-time in the business you buy

• You are using an IRA or 401k account, not a Roth IRA

• Your business is registered as a C-corporation

• You offer a retirement plan to your employees

Pros

• No taxes or withdrawal fees

• No interest or debt payments

• It can be used when entering/buying a new business

Cons

• Retirement funds depend on the business’s performance

• You must meet the requirements listed above every year to avoid taxes and fees

• Your business can only be registered as a C-corporation

Loan Against your 401k

The next option is to take a 401k loan against your account, but you can only access $50,000 or half of the money in your account, whichever is less, when taking out a loan. 

You must pay back a 401k loan in at least five years, with payments every quarter, plus the interest on the loan. 

It’s worth noting that this interest will be paid back into your 401k account, so you are essentially paying yourself.

This plan is better for those who can repay the loan with other assets. The loan application process can also be challenging and will require a large amount of paperwork. Trustworthy can help you store and organize your paperwork for easy access during the process. 

Pros

• Interest payments are returned to your account

• There are fewer requirements than a ROBS 

• The business can be registered as any type freely

Cons

• Limited to $50,000 or half of the money in your 401k

• Must be paid back in five years

• Plan administrators can set specific interest rates, payback periods, and limits on the amount of the loan

Early Withdrawal from your 401k

The final method is to withdraw the money in your 401k as cash. This option automatically elicits a 10% withdrawal penalty and income tax on the money if you are younger than 59 and a half. 

The IRS will consider you exempt from this penalty if the withdrawal is for:

• Your first home (you can only withdraw $10,000)

• Certain higher education costs

• Certain medical expenses

The downside of a withdrawal is that the money you take out will be considered income, so you will have to pay income tax; if you withdraw a large amount, you may move into a higher tax bracket. You will have to pay a significant tax in a higher bracket on your withdrawal.

Pros

• There is no limit on the amount you withdraw

• There are no restrictions on what you use the money for

• Free to buy any kind of business

Cons

• Early withdrawal penalty of 10% and income tax if you’re under 59.5 years old

• It puts your retirement at risk if you lose the money in your business

• This may put you in a higher tax bracket, costing you a lot of additional taxes

Speaking with a financial advisor before making any significant financial decisions is crucial. An advisor can help you plan and manage investments safely so your retirement fund remains intact.

Alternatives to a 401k to Buy a Business

Before deciding whether to dip into your retirement account to buy a business, consider alternative financing options. These alternatives have fewer tax penalties and no risk of affecting your future retirement fund. 

Here are other financing options to consider:

SBA Loans

SBA stands for the Small Business Administration. The SBA collaborates with lenders to present you with various financing options. 

The SBA can help you get a loan with unique benefits, such as a negotiable down payment and no collateral requirements. 

Credit Card Loan

Another option is to utilize a credit card for your investment and continuing business operations. Credit cards offer quick and easy financing and can be used for most kinds of businesses.

However, when using a credit card, monitoring and calculating your spending limits is extremely important. Any unpaid balance will put you into debt and hurt your credit score, which could have negative consequences.

Personal Loan

Those who have good credit and are confident in their ability to repay a loan can look into a personal loan. Personal loans typically offer lower interest rates and no tax risks compared to 401k loans. 

Friends and Family

Another alternative to consider is a loan from friends or family. These loans are only limited to the amount your friends and family members can give you.

To avoid future tax issues, it is crucial to register and document this money officially as a loan.

Home Equity Loan

The last alternative is to use the equity you have developed in your home or property over time. This is an excellent option if you do not have as much credit or income. 

Frequently Asked Questions (FAQs)

Is there a penalty if I use my 401k to start a business?

If you opt-in for an early withdrawal, then there will be a 10% withdrawal penalty for taking out money from your 401k if you are younger than 59 and a half years old. There are no penalties when using a ROBS or 401k loan, though.

How much of my 401(k) can I use for ROBS?

You can access as much of your 401k as you like for ROBS. However, you must have at least $50,000 in your 401k account to qualify for a ROBS. 

How much does ROBS cost?

The payments for ROBS consist of the transaction and ongoing fees. Transaction fees can range from $4,000 to $5,000, and ongoing fees can be $75-$140 monthly.

Is it a good idea to use 401k to buy a business?

It involves a lot of risks, and for that reason, you should always speak with an advisor to make sure it is the best financial choice for your situation.