Entrepreneurs have long drawn on their retirement savings, including IRAs, SEP accounts and 401(k)s, to fund a business startup or expand an existing business. It makes sense to them because they envision that their businesses will be so successful that they will be able to retire on the profits.
Another reason why entrepreneurs tap retirement savings is simply because it’s easy and available. Banks and investors demand business plans, good credit scores and accountability. They ask tough questions and usually say no to requests for urgent funding.
So, should you pull funds from your retirement savings account for entrepreneurial purposes? Well, the devil is certainly in the details.
Let’s start with a worst-case scenario. If you have to file personal bankruptcy, your pension, 401(k) and IRA savings accounts cannot be seized by business creditors. Of note, balances in IRAs (Roth and traditional) are generally protected up to $1 million from creditors. So, keeping your retirement savings in place means you never have to say you lost “everything” in a financial crisis. You have “something” to fall back on for interim living expenses.
The second reason to avoid investing retirement assets in a business enterprise is the likely obligation to pay extra taxes and penalties to the IRS. If you take money from a traditional IRA account before age 59 1/2, you will likely owe a 10 percent penalty on the taxable portion of the withdrawal, plus income tax. (Roth IRA accounts let you deposit after-tax money and make tax-free withdrawals if you meet the holding requirements.)
What's more, if you withdraw funds from a 401(k) retirement savings plan, many employers will withhold 20 percent of the amount being withdrawn. That’s expensive business funding. You might do better with a back alley loan shark!
A third reason to keep retirement funds in place — another worst-case scenario — is the potential to lose the cash value of some tax savings. When you lose money in a retirement account, you can’t offset those investment losses against current or future investment gains for tax purposes. It’s a fine point for sure, but better to be aware of it before deciding which savings accounts will be used for entrepreneurial endeavors.
Of course, there are some occasions when it might be useful to draw on retirement funds for business purposes. I won’t say the following four strategies are risk-free, but it’s helpful to know about them.
- Sixty-day withdrawals. Entrepreneurs can draw from their standard IRA accounts without incurring penalties provided they return the funds within 60 days. It’s important to keep excellent records and understand the deposit rules of the financial institution that administers your IRA account. If you are one day late in returning funds to your IRA account, then penalties will apply to withdrawn funds. You can only take out funds under the 60-day “rollover” rule once a year per IRA account. This type of short-term financing is best used when you are really certain you have a way to repay the funds on a timely basis. If you have a big customer payment coming, but don’t have enough money to cover payroll, then perhaps the 60-day IRA withdrawal might be a smarter move than maxing out your credit cards at a high interest rate.
Extra tip: To keep matters straight with the IRS, as well as any business partners, don’t forget to document the use of IRA money as a bona fide interest-bearing loan on your company’s books.
- 401(k) loans. If there’s a trend in the startup community, it’s for technology employees to keep their day jobs as long as they can before pursuing startup business ventures on a full-time basis. When I meet with moonlighting technologists, I’m frequently asked if they should draw a loan from their 401(k) account to fund patent filings and other startup costs. It’s a good question.
The right answer can be found in the employer’s 401(k) plan rules. Some employers have very lenient rules for borrowing from 401(k) assets and don’t closely monitor the use of 401(k) proceeds. Other plans only allow participating employees to borrow money from their retirement account for “emergencies” or financial hardships, which the federal government defines as payments for an unreimbursed medical expense, purchasing or repairing a primary residence, college expenses, rent or mortgage payments to prevent eviction or foreclosure, and funeral expenses.
The advantage of borrowing money from a 401(k) rather than simply withdrawing funds from a 401(k) or IRA is that you avoid paying withdrawal penalties to the IRS. Employees have to pay back the loan with interest, but since this interest just goes back into their own retirement savings account, it really doesn’t “cost” the employee anything for temporarily using the money.
So where is the gotcha in borrowing money from a 401(k) to fund a business? If you’re suddenly fired or voluntarily leave a job to pursue your venture, it’s highly likely that your entire 401(k) loan will come due in 60 or 90 days from the date of last employment. If you can’t repay the entire loan balance, then you will have to pay taxes on the loan balance, plus a 10 percent early-withdrawal penalty if you are younger than 59 1/2. That’s nasty.
- Legitimate withdrawals. In general, before age 59 1/2 there are few legal ways to withdraw money from traditional IRAs without paying early-withdrawal penalties. If you lose a salaried job and start up a business, you may be able to withdraw funds from a traditional IRA penalty-free to pay for health insurance. It’s important to check the rules carefully and document uses. Check out IRS Publication 590 for more information.
- Self-directed IRAs. Whenever I talk or write about the risks of using retirement assets to fund business needs, I can always count on some angry flame mail from financial advisors who make their living by charging big fees to help business owners tap self-directed IRAs for business purposes. Their brochures say that funding business needs through self-directed IRAs is “risk-free.” But what they don’t tell business owners is that many banks won’t lend money against assets (company stock, real estate, equipment, etc.) that are held in retirement accounts because they can’t take control of the collateral in bankruptcy court. They also don’t state the obvious: If the business can’t repay IRA investments or loans, then business owners can face tax penalties, plus the tough job of building back retirement savings.
Babson College estimates that two-thirds of the average $65,000 needed to start a business comes from personal savings. That’s a big number for most people. My view is that retirement funds are best kept for retirement. I also believe that successful entrepreneurs won’t let a little inconvenience or adversity stand in their way. In fact, they will just find another way to fund their business.
Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship and social enterprise development. She is the founder of TakeCommand, a community service organization that offers the largest centralized database of venture capital funds, angel investment clubs, incubators and microfinance lenders in the U.S. Ask her your questions at firstname.lastname@example.org.
* The Fox Business newsroom was not involved in the creation or production of this special advertising section.