Should You Fund Your Small Business with a Loan or a Retirement Account?
November 23, 2022 | Last Updated on: January 27, 2023
November 23, 2022 | Last Updated on: January 27, 2023
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Starting your own business is an exciting journey. It begins with an idea and before you know it you’ve grown your rough draft of a business plan into a successful enterprise. Of course, that doesn’t mean it’s an easy journey. There are victories and setbacks, but a solid business model and perseverance can provide a startup entrepreneur with both personal and financial rewards.
One of the most common challenges that small business owners face (and something that can either catapult or kill a company) is where to find early financing. In this article, we discuss how to use your retirement plan to fund business needs, as well as the pros and cons of doing so.
Before jumping into the details of funding a small business with a retirement account, we should first review the basics of retirement plans. Most individuals look forward to the day that they can stop punching the nine-to-five time clock and spend their golden years doing what they love with the people that matter most. To afford that dream, they rely on their retirement funds to cover the cost of living.
The most popular retirement accounts are the 401k and the Individual Retirement Account (IRA). Both types of retirement plans allow individuals to contribute money over time, earn additional funds through working and investing, are organized by a plan administrator, and gain interest income on their plan balance. One of the best parts about these investment accounts is that the gains and dividends earned are tax-free. In addition to the earnings being tax-free, contributions made into the account are usually tax-deductible.
Retirement savings accounts can be categorized into those offered by employers and those not offered by employers. Typically, investors consider employer-issued retirement accounts to be 401k accounts and those not offered by a place of employment as IRAs. However, each category contains multiple types of retirement savings accounts.
Many jobseekers consider employee benefits when searching for their next employer. Retirement plans are often included in a robust benefits plan. Traditional plans, like the 401k, usually work when the employee selects to contribute a flat rate or percentage of each paycheck into the account. Some plans also allow the employer to make an additional contribution on the employee’s behalf. The terms of matching contributions depend on the specific benefits package of the employer. While the most popular type of retirement plan offered by employers is the 401k, there are a variety of plans your employer may participate in including, but not limited to, the following plan types.
Finding a career where your company offers a 401k is not the only way to have a retirement savings account. Other retirement accounts, like those listed below, offer individuals an option for rolling over 401ks from former employers or opening a new retirement account.
For entrepreneurs that are concerned about the disadvantages of borrowing funds from a third-party lender to finance a startup, purchase a franchise, or put capital into an established business, using retirement savings is a common choice for business funding options. There are three methods of using a retirement plan to cover business expenses, including taking out a retirement plan loan, taking a distribution, or setting up a rollover as a business startup (ROBS) account.
Taking out a loan from your retirement savings account works like a traditional business loan from a lender, in that it must be repaid according to repayment terms that will include an interest rate. IRAs do not allow loans, but most 401k and 403b plans allow investors to borrow the lesser of half of their vested balance or $50,000. The loan is issued by the plan provider and is repaid by an additional contribution from the employee. If an individual leaves their employer or the savings plan, they will be required to repay the loan in full at that time.
Some entrepreneurs choose to take a distribution from their retirement plan because the process is simpler than the 401k loan. The major advantages of taking a distribution to finance a business are that the money does not need to be repaid and there are no restrictions on the use of funds. Disadvantages of taking a distribution from a retirement account include the penalties and income taxes due when withdrawing from a pre-tax plan.
The Rollover for Business Startups (ROBS) is a unique program where individuals can use the full amount of funds in their 401k or IRA account to cover business costs. ROBS is a more popular option for financing businesses because the funds are not taxable and withdrawals are penalty-free. To use a ROBS plan to finance a new or existing business, the following steps must be taken.
Just like every business decision, there are advantages and disadvantages to using your retirement plan to fund your new business. If you are contemplating whether your 401k or IRA is the right source of business funding for your new company, consider the following benefits of using a retirement account to cover startup costs.
Just as it is risky to use personal savings to start a business, there are similar cons to using your retirement account to fund your new business. Before creating your new C corporation or calling your 401k plan administrator, consider the following disadvantages.
If you do not want to risk your retirement money to finance your new business, considering loan options from a bank, online lender, or other financial institution may be a more attractive option. If you’re seeking funds for a new or established business, consider the following types of business loan options:
An SBA loan is a type of business financing where a portion of the funds are guaranteed by the U.S. Small Business Administration. SBA loan programs offer low-interest, long-term financing for entrepreneurs. Since a percentage of the loan is backed by the government, SBA loans often require a lower down payment than other types of lending options.
Term loans are a traditional type of financing where the borrower receives a lump sum of money upfront and repays the loan with monthly payments of interest and principal. Repayment terms can be long-term or short-term and the interest rate and other financing costs are determined by the lender and the creditworthiness of the borrower.
If your startup plan includes large purchases like a building, storefront, equipment, or machinery, a specialty loan might be the right loan option for you. Specialty loans include equipment financing and commercial real estate (CRE) loans.
It is possible to finance a new business or an existing business with funds from your retirement account if you take out a 401k loan, request an early distribution, or start a ROBs plan. The advantages of this type of financing include not having to meet any approval requirements or make any monthly loan payments, but the disadvantages of using retirement money for a business include the risk of losing your personal savings, having to start a C corporation, and paying the setup fees. An alternative way to finance a business is to take out a term loan, SBA loan, or specialty loan with a lender, like Biz2Credit. The experts at Biz2Credit have helped countless entrepreneurs find their startup financing, like Victor Alcazar, who was able to borrow $20,000 in just four days’ time.
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