There are significant benefits provided to people saving for their retirement in the form of pre-tax salary deferrals and a potential tax credit. Putting aside enough money is essential to planning for the future, so there are several rules and regulations in place to encourage Americans to leave their funds in their retirement accounts.
However, you may be familiar with the idea that there are legal, legitimate ways to access some, or all, or your retirement funds without taking a taxable distribution. Two of the most common ways utilize these funds are taking a 401(k) loan or using 401(k) business financing. Though the two sound similar, they’re very different, and it’s important to understand how each can be used before making any decisions.
401(k) Loan vs. 401(k) Business Financing: What are they?
The main difference between the two is that a 401(k) loan is truly a loan (borrowing money) while 401(k) business financing is not. A 401(k) loan follows the structure of a traditional loan — completing a loan application, receiving approval and making payments with interest — while 401(k) business financing, also known as Rollovers for Business Start-ups (ROBS), allows you to use your retirement funds to start or buy a business without incurring tax penalties or having to make interest payments.
401(k) business financing involves rolling funds from an eligible, existing retirement account (including 401(k)s, IRAs, 403(b)s and others) into a new 401(k) account that is provided your new company. These funds are then used to purchase shares in your new business — subsequently moving the funds to the business’s corporate account and completing the process.
Eligibility and Amount of Funding Available
If you’re looking to take a loan from your 401(k) plan, a prudent first step is to check with your benefits administrator to confirm your company’s plan allows for loans. If not, borrowing is not an option. If your plan does allow for loans, your plan document will specify the loan eligibility requirements, including the minimum loan amount, repayment terms and maximum number of loans allowed. If eligible, you can borrow up to half of your vested balance, not exceeding $50,000. So, in order to borrow the maximum amount, you must have at least $100,000 vested.
In order to qualify for a 401(k) loan, you must be an active employee of the company sponsoring the plan. Most plans require outstanding loans to be repaid in full within 60 days after separation of service. This is important to keep in mind if you’re considering leaving your job within a few years of taking the loan.
In stark contrast, most employer-sponsored retirement plans do not allow you to roll funds out of the plan until you’ve ended employment. If you’re interested in the Rollover for Business Start-ups option, this means you’ll most likely need to leave your job first. This is not the case if the funds will be rolled from a non-employer sponsored retirement account such as an IRA.
While the maximum amount of funds available for a 401(k) loan is $50,000, the amount available in ROBS financing is entirely dependent on the amount in your account. You can roll up to 100 percent of your rollable and vested funds, but most ROBS providers suggest you roll at least $50,000 to justify the administrative fees.
Utilizing ROBS can also help you obtain additional business capital if needed. Most business loans, including Small Business Administration loans and seller financing, require a down payment of 20 – 30 percent as a part of the approval process. Once you’ve completed a ROBS transaction, the funds are available tax penalty- and interest-free, and you can use the money as the down payment on the loan. Having a larger down payment increases both your attractiveness as a borrower and the likelihood of better loan terms.
How Funds Can be Spent
If you’re hoping to access your retirement funds for any other reason than financing a business, 401(k) business financing is not a good option. In fact, using Rollovers for Business Start-ups to fund anything other than an active, operating company may result in a taxable distribution. While ROBS allows business owners to use their retirement funds to capitalize a business without incurring tax penalties, it cannot be used for any venture outside of purchasing a business.
On the other hand, the funds received from a 401(k) loan can be used as you see fit. Though there are some reasons more sensible than others to borrow from retirement savings — buying a home or paying medical bills versus going on a shopping spree — sometimes it may make more sense to borrow from yourself rather than a creditor. As with any loan, it’s always wise to assess whether you can afford the monthly payments.
Repaying Your Retirement Account
The opportunity to invest retirement funds into non-standard investments through loans and Rollovers for Business Start-ups is allowed because it can result in a profit for your 401(k) account. When you take a loan, you agree to repay your retirement account with interest. Although you lose potential interest gained on the money removed from the account, your total repayments equal more than the amount borrowed because of the interest charged. Making these payments on time is crucial to your loan remaining in good standing with the IRS. Repayments must be made at least quarterly (they can be made more often) over a five-year period. If more than one consecutive quarterly payment is missed, the loan is in default and the remaining balance is considered a taxable distribution.
Rebuilding your nest egg after funding a business with ROBS looks quite different. Because ROBS is not a loan, there are no scheduled repayments to make and no amortization schedule to follow. As a part of the ROBS structure, your new company must sponsor a retirement plan, which all eligible employees may participate in, including the owner. When you begin to earn a salary for your time spent working at your company, it’s important that one consider deferring a minimum of one percent of your personal earnings into your own 401(k) account. This is an affirmative sign to any regulatory agency that your business was built to help support your retirement account.
Salary deferrals aren’t the only way to strengthen your retirement savings with ROBS. When you’re ready to sell your company, the net proceeds are returned to your 401(k) plan. And, there are strategies you can implement earlier to reduce taxes that may be due after sale. The investment dollars and any gain go directly into your personal retirement account, where they continue to grow in value exponentially or, if you are of age, you can draw from for living expenses.
When you’re deciding whether 401(k) business financing or a loan from your 401(k) account is a good idea, consider your ultimate goal. If you’re looking for debt-free business financing, ROBS can put you on the path to success. If you need less than $50,000 for help purchasing a home, paying medical bills or other life events, you may have the option of borrowing from yourself in the form of a 401(k) loan. As always, work with your accountant or financial adviser to ensure you’re making the best choice for your future.
Learn more about the ins and outs of 401(k) business financing by downloading our ebook.
David Nilssen is the CEO & Co-founder of Guidant Financial, which helps individuals secure small business funding to start, buy or grow a business with 401(k) business financing, SBA loans and more. Read more tips about finding and financing your business on the Guidant blog at guidantfinancial.com/blog.