How to Start a Business With Your 401(k): You Can Be The Bank
By Dr. Teresa R. Martin, Esq.
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A poor job market and tight lending practices are pushing many to work for themselves and find alternate ways to fund their fledging businesses.
While most people are aware of the option of using their 401(k) to purchase a home, most are not aware that the option exists to use their 401(k) to fund a business. Let's look at how you can do that.
Here is the process to set it up:
Set-up a C Corporation. You can do this yourself or hire an attorney. There is no shortage of information available online to guide you. Your C Corporation will need to create – but not issue – stock.
Have the corporation adopt a 401(k) retirement plan. This retirement plan should be a profit-sharing plan that permits all of the plan assets to be invested in company stock.
Rollover your 401(k) or IRA to the new 401(k) in your C Corporation. Keep in mind that you can have multiple sources and even multiple people involved. That includes your spouse or anyone else that's interested.
Issue stock and transfer it to the profit sharing plan. This is in exchange for the cash that was in the plan.
You can then use this cash to go out and invest the money in your business. The process is simpler than it appears. You can do it with a little help. Some companies will set everything up for you for about $5,000. They will also administer the retirement plan for ~$800 / year.
If you’re not already familiar with this process, it’s important to get professional help; the government dishes out penalties when errors are made with regards to retirement plans. So contact a professional that knows the details.
What are the Potential Pitfalls?
Lack of diversification. If you're putting all of your retirement funds into one investment, you only need one investment to fail to potentially lose all of it. Ensure you know what you're doing before you dedicate all of your funds to your business. It might be prudent to have other investments as well.
Tax issues. The IRS expects you to operate the business on a daily basis. Absentee owners aren’t looked upon favorably from a tax standpoint. There are exemptions for investing in an operating company. It cannot be a hobby and you must be attempting to sell a product or service.
Proper valuation of the investment. If you purchase a business and pay too much, you could be penalized if the business turns out to be worthless. For this reason, franchises tend to be popular because they’re easier to place a value upon.
Your salary. There are two things to consider. The IRS expects you to pay a dividend of some sort. Also, you’re taking some risk if you pay yourself from the retirement money. If you're paying yourself well and not paying a dividend, the IRS is going to look at you closely. Your salary should come from the income generated by your business.
Now you have the nuts and bolts to at least get started. Your 401(k) can effectively be used to fund a business if you take the time to do it the right way.
Experts tend to agree that if you have $45,000 or less in your retirement account(s), it's better to just take the money and pay the penalties rather than go to the expense of setting up the C Corporation.
You can own your own business, even if you can't get a loan from the bank, by using your 401(k). Do your research to find a knowledgeable professional to help you with the details and get your business into profit quickly. If everything works out, you'll never have to work for someone else again.