Businesses, no matter what the size, require money in order to operate. That becomes an issue when a business is just starting out and it doesn’t have much, or any, income. Obtaining funding is a key component to getting your start up or small business off the ground.
Maybe you’ve decided on a traditional bank loan, or maybe you’ve been lucky enough to snag an angel investor, or maybe you decided to take a leap and ask your mom, dad, uncle, sister etc…for some funds.
That said, perhaps a little part of you is thinking about your own money. The money that has been building up in a 401k or IRA. Why not use that to get your business off the ground?
401ks and IRAs: The basics
If you are considering borrowing money from yourself, then you are probably already pretty familiar with 401ks and IRAs, but it never hurts to review. A 401k is a savings plan that is sponsored by an employer. It allows you to contribute pre-tax income and usually includes a match made by the employer.
A traditional IRA, like a 401K, also allows you to save pre-tax money for retirement. However, an IRA is not sponsored by an employer, and therefore does not offer any type of employer match.
To borrow…or not to borrow…
The thought of getting anywhere near your 401K or IRA with a 10-foot pole might be sending shivers up your spine. For many of us, we feel as if we will be struck by lightning if that money is touched before age 59 1/2.
And, it’s true that taking money from either of these savings plans can come with some pretty hefty consequences. However, it doesn’t always, and in some situations it might actually be a great option.
So, when considering whether to use your own retirement as another funding source, first, better inform yourself with these facts:
9 facts about borrowing money from yourself
As mentioned above, usually 401K or IRA funds can’t be gotten to until the age 59 1/2, but there are two main ways to access that money before that.
Either through early distribution or a 401k or IRA loan.
2. Early withdrawals= taxes
What’s that old saying? Nothing is free in this world. I don’t know if that is necessarily true, but when it comes to early withdrawals from 401ks or IRAs, it certainly is. When money is distributed to an individual prior to age 59 1/2, that money is then taxed as income AND subjected to an additional 10% tax (unless the circumstances meet these criteria).
3. An early withdrawal means making a really big decision about your retirement
Think about it. When money from your retirement plan is distributed early, you are losing that money as well as any possibly investment revenue it could have earned in the future.
There are annual limits to how much can be contributed to a 401K, so it’s not like you can just make up for that early distribution.
Withdrawing money means you are choosing to invest in your business as a retirement option rather than a 401k or IRA.
4. Taking a loan from yourself is fairly cheap (compared to some other loans)
If you don’t want to be hit with that 10% tax and you are still a long ways off from 59 1/2, there is another way besides early distribution: A 401k loan.
A 401K loan can be accomplished pretty quickly, but it typically needs to be repaid within 5 years, and it includes interest payments of around 8%. Those interest payments are paid as if they are increased contributions, so you are paying yourself back and not someone else.
Some other quick lending options such as credit card advances and pay day loans often carry much steeper interest rates.
5. 401k loans are also pretty safe
They are safe because you aren’t putting anything, such as your house or family heirlooms, up for collateral.
6. There are limits on how much can be borrowed in a 401k loan
The sky, or even the total amount you have saved, is not the limit. You can either borrow $50,000 or half of what is invested, whatever the lesser number is. It’s possible that you then still need to find additional funding for your business.
7. IRA loans are a little bit different than a 401k loan
That’s because technically an IRA loan doesn’t actually exist. You can take money out of your IRA for 60 days, however, at no penalty as long as it gets paid back into a retirement account within that time period. Because of the short turnover, this may not be the best option when start a business, unless you are very confident of short term expected income.
8. The other option is ROBS
There is another way to use your retirement funds, through a process called ROBS, which stands for Rollover Business Startup Solution. Essentially, instead of distributing retirement funds early or taking out a loan, you are rolling over the retirement account and investing it in the new business. This can be pretty tricky though, and it requires careful following of the rules.
9. You should get some professional help
Whether you are looking to use your own retirement funds or funds from elsewhere to start a business, getting professional help will make everything much smoother and help you to avoid any potential hiccups.
Looking for help with getting funding for you business? Contact Lucid Advisory and Finance!