Small business lending has been on the decline since its peak in 2008, according to the U.S. Small Business Administration’s Office of Advocacy as recently cited on CNNMoney.com. As a result, countless ambitious entrepreneurs who are tired of working for someone else and who are interested in buying a business opportunity or franchise of their own are asking themselves where they can go to get the necessary start-up capital.
What many of them may not realize is that, thanks to fairly longstanding provisions in the tax code, they may be able to get the money they need by tapping into their 401K, and it’s entirely possible to do it without paying taxes or incurring penalties for early withdrawal. However, the risk involved in going this route to finance an up-start business is considerable, so it’s important to do your homework and explore all of your options before you proceed.
Two Options for Tapping Your 401K
There are two primary ways you can access the funds in your 401K to start a new business. The first is fairly traditional and relatively straightforward in that it is not much different than any other 401K loan. It involves taking your 401K savings from your old company and establishing a new 401K plan in the new business’ name, whereupon you can take a traditional 401K loan from the new firm’s plan, but only with some significant restrictions. In addition, if you don’t have the steady income necessary to repay the loan, it can all too easily go into default, which means taxes and early withdrawal penalties may then apply after all, depending on your age.
Your second option is a ROBS loan, which stands for what the IRS calls “Rollovers as Business Start-ups.” A ROBS loan is far more complicated to pull off and often requires specialized assistance in getting all the i’s dotted and t’s crossed. However, the payoff can be much greater, as ROBS loans allow you to access more money without incurring fees. When it comes to getting a ROBS loan, business valuation is a critical component of whether or not it will be approved. As a result, it may be easier to obtain a loan of this kind to purchase an existing business opportunity or franchise based on a proven business model than it would be an entirely new start-up.
While it’s true that funding a new business venture with your 401K assets can be a risky endeavor, many would argue that when you borrow money from any source, you’re taking a significant risk. After all, most standard loans require you to put up valuable collateral, impose substantial interest rates and obligate you to oftentimes painful terms, including having to make payments before you've even made profits.
Of course, financing a business with 401K money isn’t for everyone. It’s a serious gamble, one that can certainly break your future. To be fair, it’s also one that a number of now successful entrepreneurs have found has made theirs. The fact is that no one else will ever believe in you as much as you do. Once you know what’s at stake and what the possible trade-offs might be and you’ve honestly assessed yourself and the likelihood that you’ll be successful, the question boils down to this: Are you worth the risk?