How do you finance a business with 401K? What are the steps and requirements involved? Is it wise to start a business using 401K? How do you start a business using your retirement fund?

If you seek answers to the questions above, then below is a beginner’s guide to financing a business with 401K.

There is this usual saying that stuck to my head when i was a child. “Opportunity comes but once” Maybe because i heard a lot of people use that phrase at the time though i didn’t really understand it practically. Well, now i can say i understand a lot about opportunities and taking hold of them whenever they present themselves because opportunities don’t last forever and if you do not take hold of it, someone else will.

Sometimes, business opportunities present themselves but due to financial constraints, you might not be able to go ahead with your business plans. In fact, this is the major clog in the wheel for people who have smart business ideas. Funding is almost always the problem because even if you decide to take a loan, you might have a difficult time convincing the bank that your project is truly a viable one. This is the sole reason why i wrote “The Ultimate Guide to Small Business Financing.”

A new system of funding businesses is gaining popularity amongst Americans and it is known as ROBS. ROBS is an acronym for Roll over as Business Start up. It could also mean Retirement Owned Business Start up. Other people might choose to call it 401(k) small business financing. It is a system that allows Americans to make use of money from their Individual retirement account (IRA) or retirement savings to fund their businesses.

401(k) business financing is mainly used by Americans who are between the ages of 40 and 55 and have more than fifteen years working experience in corporate America. In addition to this, your credit report must be on the positive side and you must own at least one home to be able to qualify for this method of business financing.

ROBS is a system of funding that allows you an opportunity to buy stocks of your own business instead of buying stocks of another company. Though there are taxes and penalties that are charged for early withdrawal of your retirement savings, you would be able to avoid such penalties if you make use of the right service provider who would execute on your behalf. The employee retirement income security act of 1974 provides coverage for you that help you to avoid paying taxes and penalties when you decide to use ROBS to finance your business.

It is also important that you are aware of the risks involved with this method of business financing. Financing your business with your retirement savings has some potential risks which have to do with losing your money if anything goes wrong with the business. You should therefore be careful if you decide to opt for this method of funding and ensure that the business you want to invest in is a viable one with potential for growth. Every business has its own risks but a smart investor must be able to identify and analyze those risks so that you can prepare for them in advance. So what steps should you take to access this type of business funding?

6 Steps to Financing a Business With 401(K)

1. Create a business plan-: The first thing you should do is to draft out a detailed business plan outlining all the things you would need for the business as well as the financial implication. You should ensure that you list out all the equipment needed and their costs as well as employee costs. This would give you a clear idea of how much it would cost to start the business and you would know the exact amount that you need.

2. Choose a service provider-: The next step is to look for a service provider that would help you carry out the execution and also offer you advice and guidance on how to go about it, so that you can avoid paying huge penalties and taxes on early withdrawal of your funds. Popular service providers include:

  • Benetrends
  • Guidant Financial
  • Bellevue

3. A new C-Corporation is opened-: To meet the legal requirements for this kind of business funding and in compliance with the Federal income tax law of the United States of America, a new C-corporation would have to be established. Other forms of business entities are not approved. The new C-corporation would as the operating entity of the new business.

4. New 401(K) or Pension Service Provider is sponsored by C-Corporation and your retirement savings are rolled into the 401(k) or PSP account.

5. 401(k) plan invests in stocks of new business-: This is a simple breakdown of how the system works. You invest in a new c-corporation and the c-corporation in turn, invests in your new business. Your 401(k) would own shares in a new c-corporation and the c-corporation would be in charge of running your business. Remember that to establish a 401(k) you must have at least one joint-owner of the business that would also have equal rights and share of profits with you.

6. Another legal requirement is that you must be actively involved in the business which means that you must be an employee of the business and you can earn salary as long as the business is making profits that would justify the amount apportioned as salaries. Salaries must also be reasonable.

Your business could also obtain other loans on financing but with the following cautionary notes-:

  • The 401(k) cannot be used as a security for any loan obtained for the business.
  • The business cannot obtain loans from related parties like friends, family members, and officials of the company, clients, suppliers or even you.

Also, you cannot invest your personal funds into the business and you cannot use your 401(k) funds for personal use such as buying houses, cars, or any other personal expenses.

How to Start a Business With 401K

It is indeed wise to invest your 401K funds but not a lot of people know how to start a business using 401K. Before considering starting a business, the first thing to do is ask the experts about the possibilities of funding your business using 401K.

There are many companies with services geared towards assisting customers in transferring funds from the 401K to the new business. However, you should make sure you have the right business opportunity and plan on hand. Learning how to start a business using 401K is not really that hard except for its legal complexities. The process of starting a business using 401K begins by establishing a C corporation, one that has not issued stock.

In the course of starting a business using 401K, it is important to seek the advice of a certified public accountant to handle the formation of a corporation and retirement plan. It is also very crucial that you work with experts that are familiar with Employee Retirement Income Security Act and know the laws on employee benefits plan.

How to Reduce Risk When Starting a Business With 401K

There are risks involved when starting a business using 401K. As in any kind of business, using the 401k as an investment is a gamble because if the business fails, you may not only lose the business but a significant amount of your retirement fund.

a. You should make sure that the company you are forming is an operating one. What I mean in essence is that the company should be actively engaged in the sale or exchange of products and services and the 401K funds should be for expansion. This will help reduce the risk of failure.

b. Run Lean

Another way to avoid losing your retirement fund is to make sure that any company you are investing in is fairly valued, so as not to waste money investing in a business that is not sellable. If you are the head of the company or you run it, it is advisable that you do not pay salaries from the 401K but from future operating profits. This is because the IRS lets business owners of C corporations pay dividends and this can potentially bleed the 401k investment.

Establishing a C corporation is just one of the ways to start a business using 401k. Experts will say there are more. What’s important is to make calculated moves before doing the investment. Take note of the taxation involved upon the withdrawal of the 401K fund. Any movement of money from the 401K will be taxed anywhere from 10% to 35% from your income tax rate. If you are under 59 and half years old, there is a 10% additional penalty for early distribution.

Starting a business using 401K successfully entails asking business owners with years of experience how they overcame challenges and handled the different crises that erupted. This move will give you an idea of what to expect ahead. There is so much competition in the business world and betting your  401k funds is indeed a huge risk, so you need to do all it takes to reduce the risks. Finally, you must be prepared to start small and learn the ropes of the industry you will be doing business in. It is considered a shrewd and rewarding move.

In conclusion, before you go ahead to embrace this source of funding for your business, it is advisable for you to learn all you must about it. Do a lot of personal research, ask questions, approach your bankers to educate you more on the process and ask questions from people who have used this method of funding before to help you know if it is the right method for you.