Pros and Cons of Cashing Out Your 401(k) to Start a Business
The combination of a bad lending environment, the economy, and the uptick in people starting businesses have made tapping retirement funds a very tempting business financing option. Is it right for you?
If you listen to any of the financial experts, the message "never touch your 401(k)" gets repeated over and over. Frankly, I think Suze Orman would blow a gasket with the idea of hedging your retirement assets on a business idea. Yet it is happening more frequently than you think, it is legal (if certain tax code provisions are followed), and it doesn't have to be the all-or-nothing doomsday scenario.
A recent article in Inc. Magazine details "How to Finance a Business with your 401(k)". Here's how it works. Essentially you establish a C corporation for your new business that has been created but has not issued stock. The new corporation adopts a retirement plan. You roll over your 401(k) to the new corporation's plan. The new corporation issues all of its stock and transfers it to the new profit-sharing plan in exchange for the cash. Voila, instant cash flow.
The process of using a rollover as business start-up is often referred to as "ROBS." You can read more about this in Tapping Retirement Money for Your Business? Be Careful. It is particularly appealing for franchise opportunities:
But an article published in Franchise Times cited compelling figures from franchise-data firm FranData that showed more than 4,000 businesses started using ROBS funding last year. More than 60 percent of those businesses were franchises.
Back in 2008, the IRS did express its displeasure about the ROBS plans in a retirement-plan newsletter, so Uncle Sam may not be as enthusiastic about this approach as some entrepreneurs.
So is it right for you or not?
The Franchise King had this to say about using your 401(k) to fund your franchise business. Bottom line? Get educated, make an educated decision ... for you.
Here are some pros and cons to consider:
- Relatively quick and easy access to potentially large sums of cash without having to qualify for a loan.
- You leverage your own cash to build something of value, essentially becoming your own venture capitalist (needless to say, this is only a positive if the business thrives).
- Up to 100 percent of your retirement funds can be used, but you can diversify and use only a portion to fund your business venture leaving the rest of your retirement assets intact.
- You put your future retirement and financial security at risk should the business fail.
- Must hire a tax attorney or CPA to handle the formation of the corporation and retirement plan.
- These provisions may be under scrutiny (or that is the picture some paint) by the IRS.
Have you used your 401(k) to fund your new business? Any thoughts, resources, or experiences with this approach? Please get the conversation rolling in the comments.
Paula Gregorowicz, owner of The Paula G. Company, offers life and career coaching for women to help you figure out what you want to do with your life and career and cultivate the confidence to be the person you most want to be so you succeed on your own terms. Learn more about The Life Alchemy Success Formula™ and Get the free eCourse "5 Steps to Move from Fear to Freedom & Experience Greater Confidence" at her website.