How to Use 401(k) Financing for Your Business Acquisition

Katie Fleming

Katie Fleming

Co-founder and COO of Owner Actions

A person at a computer considers using his 401(k) for financing his new business.

You have many options for attaining the funding you need to finance a business acquisition. But if the idea of hefty loans and debts to third parties makes you feel uneasy, consider another option. Use your own money to fund all or part of your acquisition, especially through a 401(k) financing option.

There are three ways you can use your retirement accounts to cover the costs of your purchase:

  1. Access the money in your 401(k) with a 401(k) loan.
  2. Access the money in certain retirement accounts by setting up a rollover as business startup (ROBS).
  3. Take a distribution from your retirement savings account.

 

401(k) loan

What is a 401(k) loan?

Through a 401(k) loan, you may be able to access up to $50,000 or half of your vested balance (whichever is less) to finance the acquisition of a business. Your 401(k) provider will facilitate the loan, and the terms of that loan will include regular payments of principal and interest.

As the 401(k) holder, you are the owner of the funds you’re borrowing. Because of that setup, you will repay yourself both the borrowed balance and the interest required for the loan. The interest payments may help you offset the investment gains you might have realized had you not accessed those funds.

An important condition of this loan is that you must remain employed and enrolled in your employer’s retirement plan offering for as long as the loan is outstanding. If you resign or are terminated from your job, then you’ll be required to repay this loan within two months of your departure. Because of this condition, many entrepreneurs who use this option do it to fund a side business rather than a venture that requires their full-time involvement.

It’s also important to note that some plan administrators have strict requirements about how these kinds of loans can be used. For instance, it’s common for administrators to prohibit participants from drawing funds to finance a competing business. Be sure to speak with your plan administrator about use limitations before pursuing this option.

 

Do other retirement savings plans offer loans, too?

In some instances, you may be able to borrow against a 403(b) or a 457(b) loan, depending on the terms set by your plan administrator. However, it is not possible to take out a loan against your IRA.

 

How much can I borrow?

You can borrow up to $50,000 or half of your vested balance, whichever is smaller.

 

What are the terms?

Your plan administrator will set the specific terms of your loan, but there are some common terms. Often, the interest rate on a retirement plan loan is 1% plus the prime rate, and most loans require a repayment term of five years. Additionally, some plan administrators charge fees to issue and administer these loans.

 

What are the risks?

There are four important risks to consider:

  1. The money you withdraw will no longer be invested, so you may miss out on opportunities for investment returns.
  2. Your inability to repay the loan could result in IRS penalties. If you fail to repay the loan, the IRS will recategorize your loan as a 401(k) withdrawal, which may subject you to income tax liabilities and a 10% early withdrawal penalty (if your age is less than 59 ½).
  3. Your inability to repay the loan will also result in the permanent loss of a portion of your retirement savings.
  4. If you resign or are terminated from your job, you will be required to repay the full balance within two months of your departure.

 

What about the advantages?

There are many advantages to 401(k) loans over other sources of financing. These include:

  • Low interest rates and the ability to earn interest on your repayments
  • Easy qualifications with no credit check
  • Not being under obligation to a third party for financing
  • The avoidance of taxes and penalties on the 401(k) money you access, provided you repay the loan under its prescribed terms
  • The default on your 401(k) loan won’t be reported to credit bureaus, and it won’t impact your credit score or ability to attain future financing

 

When do the advantages outweigh the risks?

The advantages may outweigh the risks in the following circumstances:

  • You need a relatively small amount of money to afford an acquisition.
  • You will remain employed and enrolled in your retirement plan for the duration of your loan.

 

Rollover as business startup (ROBS)

What is a ROBS?

ROBS is the second option for accessing your retirement savings account to acquire a business. This option is more complex to set up, but it also offers more flexibility for the entrepreneurs who choose to use it.

In a ROBS arrangement, you will create a business entity that will buy a business. You will then roll your retirement account money from your self-directed account or employer’s sponsored account over to a new retirement account at the business entity you create. Your retirement funds provide the entity with the capital it needs to cover the startup costs.

There are five steps to making this happen:

1: You must establish a new business that is a C corporation entity.

2: You must establish a retirement plan at your new business that can accept rollover 401(k) money or other forms of retirement savings.

3: You must enable your new business to sell stock to the retirement plan you've set up.

4: You must roll your retirement funds from your 401(k) or another qualifying account over to the plan you've established at your new business.

5: You must purchase the stock that your business issued with your rollover funds.

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Here is an example of how this works:

Rex has $120,000 of vested money in his employer-sponsored 401(k) account, and he’d like to use it to buy Sandwiches and More, a local sandwich shop.

To facilitate this deal, Rex creates a new business entity, a C corporation, which he names Rex’s Restaurants. He works with a ROBS provider to set up a retirement plan at Rex’s Restaurants. Then, Rex’s Restaurant issues stock that’s available to participants of Rex’s Restaurants’ retirement plan.

Rex requests a rollover from his 401(k) account to his new retirement savings account at Rex’s Restaurants, and he buys 100 percent of the shares his new business offers.

Through this transaction, Rex’s Restaurants raises $120,000, which it uses to buy Sandwiches and More. Now, Rex’s Restaurants owns Sandwiches and More, and Rex owns stock in Rex’s Restaurants.

.

This process can be complicated, especially because it will require you to navigate IRS regulations, legal concerns, and the issuance of stock. Most owners who choose this route work with an attorney or ROBS provider to help them through the process.

Would you like to connect with an attorney? Click the button below to get started:

If you'd prefer a ROBS advisor, consider one of these options:

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Which retirement accounts qualify for a ROBS arrangement?

An attorney or ROBS provider will help you determine which of your accounts qualify for a ROBS arrangement, but generally, you may use funds that are available in any of the following accounts, provided you are parting ways with your current employer or, if staying, your plan allows in-service rollovers:

  • Roth or traditional 401(k)
  • Traditional IRA
  • SIMPLE IRA
  • SEP-IRA
  • Roth or traditional 457(b)
  • Roth or traditional 403(b)
  • Keogh plan
  • Thrift savings plan (TSP)
  • Some employer profit-sharing plans
  • Some traditional pension plans

 

At this time, Roth IRAs cannot be used to facilitate a ROBS transaction.

 

How does ROBS differ from a 401(k) loan?

Unlike a 401(k) loan, ROBS requires no repayment of debt. ROBS is not a loan program. Instead, it’s a way to purchase equity in a business that wishes to raise capital to acquire another business. Because of this arrangement, there are no obligations to make monthly repayments, pay interest, or meet other terms that are required of loans.

ROBS arrangements also differ from 401(k) loans in the amount of money that can be utilized. In a 401(k) loan, $50,000 is the maximum that participants are allowed to borrow. In a ROBS transaction, $50,000 is the minimum that participants are allowed to rollover.

 

What are the qualifications?

There are three qualifications for eligibility:

  1. You must have at least $50,000 in a qualifying retirement account.
  2. You must establish a C corporation entity that can accept your retirement plan rollover and issue stock to raise capital.
  3. You'll need to commit to being an employee of your C corporation and receive a salary from that organization (although the salary may not be paid from the capital the business raised from your retirement plan rollover funds).

 

What are the costs?

If you choose to work with a ROBS provider, you may be charged an upfront fee to set up both your C corporation and retirement plan and issue stock certificates. Often, this fee amounts to about $5,000. You may also be charged an ongoing administration fee, which may be as much as $200 a month, to ensure your compliance with retirement plan regulations.

 

Do 401(k) loans and ROBS arrangements share the same risks?

Both options can result in a loss of retirement funds. However, you could lose a significantly greater amount of money in a ROBS arrangement, which does not limit the amount you can roll over to purchase a business. Because 401(k) loans allow a maximum of $50,000 to be used for startups and business purchases, borrowers don’t stand to lose more than $50,000 of retirement savings. People who enter a ROBS arrangement can lose the full amount of their rollover, which may be much greater than the $50,000 minimum, if their business fails.

 

When should I choose a ROBS arrangement over a 401(k) loan?

There are several scenarios in which a ROBS arrangement may be a better option than a 401(k) loan:

You plan to quit your day job.
ROBS arrangements can help you navigate one of the key limitations of most 401(k) loans: having to stay employed by your current employer. While people who choose a 401(k) loan will need to repay the portion they borrow shortly after leaving their roles with their employer, people who choose a ROBS arrangement can roll over their 401(k) accounts to their new entity and leave their jobs without any repayment requirements.

When you need more than $50,000.
A 401(k) loan cannot be greater than $50,000. Participants who need more can choose a ROBS arrangement that allows them to access a greater portion of their retirement savings.

When you’re worried about repayment.
A 401(k) loan must be repaid, even if the venture it funds fails, to avoid taxes and penalties. However, money that’s accessed through a ROBS arrangement does not require repayment.

When you want a say in how your retirement money is managed.
In a ROBS arrangement, you have the authority to choose how your new 401(k) is established and managed, and you aren’t restricted by the terms of your employer’s plan administrator.

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Before selecting this approach, you should consider the risks, the challenges you may face in establishing the C corporation, and the costs you’ll need to cover to attain assistance from an attorney or ROBS provider. You should also recognize that you may be at an increased risk for an IRS audit to verify your compliance with ROBS regulations.

 

Distributions

Wouldn’t it be easier to take a distribution from my retirement account?

Distributions are a much simpler process with some clear advantages: There are no repayment requirements and no limitations on how you can use the money. However, there are important considerations to keep in mind. The first is your age. If you are age 59 ½ or older and are withdrawing from a pre-tax plan, you will be required to pay ordinary income taxes on the distribution. If you’re under the age of 59 ½ and withdrawing from a pre-tax plan, you will be required to pay income taxes on the distribution, and you may be required to pay a 10% early withdrawal penalty.

A tax advisor may be able to suggest strategies for avoiding this penalty, including repaying the full balance within 60 days of your withdrawal or taking substantially equal periodic payments over a five-year (or longer) period.

Need a tax advisor? We can help. Click the Connect button below to connect with an attorney in your area:

The second consideration is risk. By withdrawing from your retirement account, you sacrifice a portion of your account balance and the earnings you may have gained on it. If the business you acquire performs well, you may earn the equivalent (or more) of the interest you’d have missed by holding the funds in your retirement savings account. However, there is also a chance of losing the funds you withdraw in their entirety. Because of this, retirement account distributions are highly risky and should be considered carefully before proceeding.

 

How can I decide which 401(k) financing option is right for me?

A fractional CFO can help you determine how each of these options may affect your financial future. This person, who can devote hours each week, month, or quarter, can help you weigh the risks and costs against the possible benefits to find an option that’s suitable for you.

Would you like to connect with a fractional CFO? Take a look at a few of our favorites:

 

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Retirement plan financing isn’t your only option for attaining the funding you need to acquire a business. Check out this article to assess other options, including partnerships, term loans, asset-backed loans, SBA 7(a) loans, and seller financing:

 

 

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