One of the greatest aspects of the American Dream is starting your own business. Maybe you are a part-time entrepreneur that has the security of a “9 to 5” career while you transition into full-time self-employment. Or maybe you are close to retiring and want to start a business that gives your more freedom and control in your gold years. You might be a full-time entrepreneur. Regardless of your situation, if you’re like many business owners, raising capital for your business can be challenging. It can be difficult to get a business loan from your bank. If you bring on other business partners who may have cash to infuse your business, that can come with a price. You may decide to enter into the arena of private offerings as a way to raise capital for your business, but that too comes with a price.
If you’re like most Americans, your retirement account is your largest asset and your largest source of capital. It’s a somewhat unconventional approach to business funding, but I have talked with many business owners who would love to use their retirement account to provide operating capital for their business. Whether this is a good financial decision is something for you to decide. You know more than anyone that running a business can be risky and using retirement funds towards your business could drain your retirement account, leaving you without the necessary funds when you retire. The problem is that many small business owners in America have so much going on that they can only worry about today, much less when they retire. If you’ve wondered if you can use your retirement account to infuse cash into your business, then keep reading.
One option is to take a distribution from your retirement account and use the distributed amount towards your business. However, if you’re in a high personal income tax bracket, and depending on your age, the taxes and penalties could be expensive since the amount you take as a distribution is included in your personal gross income. But if you are over 59 ½ or otherwise qualify to avoid the early withdrawal penalties, and you are in a lower personal income tax bracket, this may be a reasonable option. Keep in mind that the distributed amount could push you into a higher income tax bracket. It’s a good idea to run the numbers to be sure.
Don’t worry, I didn’t write an article to tell you to take a distribution from your retirement account. However, if you don’t take a distribution from your retirement account to fund your business, but you want to nevertheless use retirement funds in this way, one problem you’ll encounter is that your business is a disqualified party to your retirement account, which means the general rule is that you cannot use your retirement account to provide working capital for your business. However, one notable exception to this rule is the 401k loan. You can use the 401k loan proceeds for virtually any purpose, including towards your business without triggering a prohibited transaction.
The 401k loan can be a great option for someone whose business is running low on capital. But before you run out and get a 401k loan, here are 5 things to know before taking out a 401k loan to fund or continue operations of your business:
- Check your 401k plan documents to make sure your plan allows the 401k loan option. If you have your 401k with an employer, it is quite probable that the plan documents will have limitations on what the 401k loan can be used for. Therefore, the best vehicle for using the 401k loan in your business is typically going to be the self-directed solo 401k.
- The maximum amount of the 401k loan is $50,000 or 50% of the 401k account balance, whichever is less. The maximum amount of the 401k loan is $50,000 or 50% of the 401k account balance, whichever is less. For example, if your 401k account balance is $25,000, the most you can take as a 401k loan is $12,500. If your 401k account balance, is $1,200,000, the most you can take as a 401k loan is $50,000.
- It must be paid back within 5 years with interest – Payments must be made at least quarterly. Yes, you must pay it back. Per IRS regulations, the interest rate should be 2% above the prime rate. Payments must be made at least quarterly and the payments must be in accordance with an amortization schedule where each payment consists of principal and interest, i.e., no interest-only payments with a balloon payment at the end. We’d all prefer to pay interest to our 401k than to a bank.
- 401k Loans Are Usually Only Available to Current Employees. In most situations, 401(k)s will require you to be an existing employee of the company in order to take or maintain a 401(k) loan. So, for example, if you have an old employer’s 401(k) then you will typically not be able to take a 401(k) loan from that plan as you are not longer employed there. Also, if you are working for an existing employer and you plan to take a loan and then leave that employer, most 401(k) plans will require re-payment immediately upon termination from employment. Because of both of these situations, a new business owner should rollover their current 401(k) funds a new solo 401(k) in the new business. They would then take the 401(k) loan from the new self directed solo 401(k) created by the new company.
- Any amount of your 401k loans that is unpaid when due becomes distributed and taxable to you. If you don’t pay back the 401k loan when it’s due, the outstanding principal amount is distributed and must be included in your personal gross income for that year.
For example, here’s Johnny. He works full-time for a Fortune 1000 company but he also has a business he started last year. He needs more capital for his business but his business hasn’t built up corporate credit to get a business loan, even with personal guarantees or personal financing. He has a 401k from a former employer that he rolled over to an IRA last year. He decides to set up a self-directed solo 401k that would be adopted by his business and he rolls over his IRA to this solo 401k, which has about $175,000. He then takes out a 401k loan of $50,000, which he uses for marketing, and to outsource other business operations that he doesn’t have time for right now. He is hopeful that this will get his business in a better situation and put him one step closer to transitioning out of his full-time corporate job. As long as Johhny makes his quarterly payments of principal and interest and pays back the $50,000 within five years, he won’t pay any taxes, and who else to pay interest than to his own 401k. Johnny is one step closer to living the American Dream thanks to the 401k loan.
Remember, the 401k loan option is not for everyone. But it is one of many benefits and options that come with setting up a self-directed solo 401k. Our firm can help with setting up a self-directed 401k plan. Our fees are reasonable, and in fact, we are running a promotion on our solo 401k until November 25th. If you want to setup a solo 401k and make tax deductible contributions for the 2015 tax year, you’ll have until December 31th to form and adopt your solo 401k. For more in depth articles on 401k deadlines, contribution limits, etc., please check out our law firm blog as well as www.navbrs.com, www.sdirahandbook.com, and www.markjkohler.com.