Entrepreneurship is one of the most important developments of modern economic life. Entrepreneurs help create new companies, which spur economic growth, create jobs, and introduce new technologies, products and services that improve our living standards and quality of life.
Starting a new business or franchise is not easy and is quite risky. Hundreds of thousands of small businesses open and close every year. In addition, about 20% of businesses fail in their first year, and about half of all businesses close after five years.
For many people, the hardest part is not coming up with a business idea or a potential business to buy, but finding the capital needed to start or buy the business. Too often, an entrepreneur doesn’t even know that using retirement funds could be an option for investing in a new business.
Funding new business ventures has become a popular TV phenomenon. As the producers of the reality show Shark Tank know, watching would-be entrepreneurs market their business ideas, products or services has become extremely popular with the American public.
The first place entrepreneurs typically start when looking to fund a startup is personal savings. If they do not have sufficient personal savings, then third-party loans, such as Small Business Association loans, are a popular option. However, if acquiring a loan is not viable for you, then seeking third-party investors is often the last resort.
Unfortunately, in my experience, far too many entrepreneurs are not aware that the use of a retirement account as a business funding source could end up being the most tax-efficient option. In general, there are three ways retirement funds can be used to start or fund a business:
Taxable Distribution
In the case of an individual retirement account, or IRA, you may take a taxable distribution at any time. However, taxes will be due, and an early distribution penalty will apply if you are younger than 59 ½. Roth IRA distributions are tax- and penalty-free at that age. Before that, only contributions made to the Roth can be withdrawn without consequences.
Unlike an IRA, a 401(k) qualified plan or other pension plan must satisfy certain “triggering rules” before the funds are accessible. Essentially, one must reach the age of 59 ½, separate from their job, or suffer a hardship before gaining access to the plan funds for distribution purposes.
The downside of taking a distribution from your retirement plan is you are taking out funds that are growing in a tax-advantaged way. Moreover, if you are younger than 59 ½, you will be hit with that 10% early withdrawal penalty.
401(k) Plan Loan
If your 401(k) plan allows for a loan, then you would be able to borrow the lesser of $50,000 or 50% of your account value. The proceeds of the loan can be used for any purpose, including starting a new business. You will generally have up to five years to repay the loan. Payments must be made at least quarterly, at an interest rate of at least prime, which stands at 4.75% as of this writing.
The advantage of using the loan option to fund a business is you can get tax- and penalty-free use of your 401(k) savings. Further, you avoid paying a higher rate with an outside lender, and all interest is paid back to the plan.
However, you are limited in the amount of funds you can borrow. If your 401(k) balance sits at $50,000, you may only borrow half that amount — not exactly a ton of money to work with. As with the taxable distribution, any money borrowed from the plan will not be earning from other investments.
ROBS
The Rollovers as Business Start-Ups project (ROBS) allows you to use your retirement funds tax- and penalty-free. There’s no limit as to how much of your funds you may use. Plus, you are allowed to personally be involved in the business and take a salary, without breaking any of the prohibited transaction rules.
The ROBS option typically involves the following sequential steps:
1. An entrepreneur establishes a new C Corporation.
2. The C Corporation adopts a 401(k) plan, which can invest in company stocks, called “qualifying employer securities.”
3. The entrepreneur rolls over or transfer funds from their retirement plan into the new 401(k) plan.
4. The C Corporation’s stock can then be purchased at fair market value.
5. And finally, the sale of the stock generates the capital needed to fund the business.
It is important to note you must use a C Corporation when setting up a ROBS. You cannot utilize a limited liability corporation, sole proprietorship or any other type of entity. The drawback of the C Corporation is the double taxation. The business gets taxed first, and then, the shareholders also get taxed.
Which Is Right For You?
Each of these three concepts has both positives and negatives. A lot of factors go into deciding which path to take, including how much money you have and need, where your money is and your age. But if all other options seem out of reach, looking at your retirement savings may provide the boost you need to go from an employee to calling the shots as the boss.
This article originally appeared on Forbes.
