Raiding the Retirement Fund Could Shortchange Your Golden Years
June 1, 2011
Starting a business is a dream for many people. The motivation to start a business may come from being laid off or from a desire to be one’s own boss—or from the urge to launch a second career following retirement. No matter the reason for wanting to start a business, just about every business takes capital to get off the ground. One possible source of startup money can be a person’s retirement savings. But is using one’s retirement savings to start a business ever a good idea?
A Taxing Situation
Lon Jefferies, of the Net Worth Advisory Group, says that, “Borrowing or withdrawing from a retirement account can be fast, easy and inexpensive, or even free, if withdrawing contributions made to a Roth account.”
It’s easy to see why the access to quick cash is tempting for would-be entrepreneurs. But there are tax implications for raiding the 401(k). Most 401(k) plans allow an employee to borrow the lesser of either $50,000 or half the vested balance. The loan must usually be paid back within five years or it will be counted as a taxable distribution. If the employee is under the age of 59.5, there is an additional 10 percent early withdrawal penalty.
An outstanding loan from one’s retirement account may also cause an employer to stop any match it is offering on contributions to the plan. If an employee quits or is let go by the company, any outstanding loan amount may have to be paid back immediately. If the loan can’t be repaid, the distribution becomes taxable.
Subject to certain rules, money can also be taken from both a traditional IRA and a Roth IRA. Once again, there are possible tax consequences and early withdrawal penalties one needs to be aware of when taking money from any qualified retirement account or fund.
“Utilizing a retirement account for funding a business can be incredibly risky,” says Jefferies. As optimistic as one may be about starting a business, the reality is that many startups fail.
The older a person is, the shorter their time horizon for recovering from a business failure. “Starting a business at any stage in life is risky, especially when it is done later in life using one’s retirement savings. If someone plans to retire in the next 10 years, it might not be a good idea to use retirement funds to start a business. On the other hand, if someone has 25 years of working life left, they might be in a better position to recover from a loss of their retirement funds,” explains Brad Thurber, vice president of D.A. Davidson.
Allen Hughes, senior financial planner with Deseret Mutual Benefit Administrators, adds, “A retirement account is to serve as a source of income replacement when you are no longer working. It should be a relatively conservative portfolio that will be there come thick or thin to replace the lost income a person experiences when he or she reaches a point in life when they are no longer working. It isn’t supposed to be a source of speculative funds.”
Another possible way to use retirement funds to start a business is doing something called a Rollover for Business Startup or ROBS. Essentially this is a process by which a new corporation is formed. The new corporation establishes a qualified retirement fund. The employee takes his or her existing 401(k) and rolls it over into the new company’s qualified plan. The employee then elects for their new retirement plan to purchase the stock of the newly formed company. The company receives the cash and the plan holds the stock.
This is a legally complex process that can be fraught with risk if not done correctly. Lorin Barker, a tax attorney with Kirton and McConkie, advises seeking experienced legal and tax advice whenever considering using retirement funds to start a business.
Given these considerations, financial planning professionals agree that it is wise to consider other sources of funds for starting a business. They advise looking into SBA loans, obtaining a second mortgage or an equity line on a home, using a low interest rate credit card, or even borrowing from friends and family. Starting one’s own business can have great rewards both personally and financially. One just needs to be well informed and consider all the pros and cons of using retirement savings to do so.