Financing Your Business: A Case for Using Some of Your IRA, SEP, or 401(k)
Brian S. Orol, Certified Financial Planner, Brian S. Orol C.F.P.
Remember what your Mom used to say to you when you and she were shopping in an expensive store? "Look," she would warn you, "but DON'T TOUCH." These days, such a warning could apply to using tax-deferred retirement funds to fund start-up businesses. The prevailing wisdom holds that you should sock away money in these accounts, never, EVER touching it--unless you're ready for year-round golfing.
When looking for cash to start or expand their businesses, however, corporate refugees or diehard entrepreneurs (those on second, third, or subsequent ventures) might be well-advised to consider using their IRAs, SEPs, or 401(k)s. One reason is that unless they're launching anybusiness-dot-com, venture capitalists won't be knocking down their doors. If your company is a typical one- or two-person start-up, you might find it difficult to get loans from family, friends, or special government programs.
Another reason for considering those funds is that you'll be making tax-wise use of your resources. Because you've enjoyed tax-deferred growth in these accounts, you have more money available than would otherwise be the case. When you use it to create wealth, you're allowing yourself access to your own venture capital fund.
Timing is Everything
Before you jump up and say, "Eureka!", remember that timing is everything. You must be careful about when you go into your retirement kitty. At the start of your venture, it is probably smart to consider personal savings first, leaving an emergency fund equal to three months' living expenses to assuage the no-salary jitters. Into the savings category, add employee stock options you have exercised.
Next, turn to more easily accessible capital sources: the equity in your home, making sure to access only a portion--perhaps a fourth to a third--of what's available to you; loans from family or friends with fixed interest and payback stipulations; and credit from government and other specialty programs.
At this point, if you need additional cash, using retirement funds begins to make sense. You must still tread carefully. You don't want to risk your largest source of retirement income. Be sure your business plan has been shot full of holes by mentors and put back together again. Be confident about your ability to walk away and find employment if the venture doesn't succeed.
And be careful. Leave a minimum of $50,000--ideally $100,000--in your plan. If you are 55 or older, leave even more. But then, be willing to take the plunge. What follows is how you do it.
Technique Matters, Too
Though all are tax-deferred, IRAs, SEPs, and 401(k)s are not created equal when it comes to harnessing their wealth-creating potential. The most advantageous are 401(k)s; less so, SEPs and IRAs. So if you're a salaried employee with a 401(k), head straight for that account, preferably prior to trading your job for self-employment.
What makes a 401(k) such an attractive financing source is that under most employers' plans, you can borrow up to $50,000 from your account. You must repay the loan within a set period of time, usually 10 years or less, but the interest rate is a nominal 2 or 3 percent. Better yet, because the funds aren't considered withdrawn, you aren't subject to taxes or penalties. The only catch: under most plans, you must exercise this privilege before you leave your job. That means you might be borrowing prior to needing the money for your business.
Unlike 401(k)s, Individual Retirement Accounts and Simplified Employee Pension plans do not allow you to borrow against them. You can, however, access the money in these accounts simply by liquidating whatever mutual funds in which you've invested, getting a checkbook for the account and writing checks for business expenses.
The big caveat is that withdrawals are subject to an Internal Revenue Service double whammy: a 10 percent penalty and income taxes. The amount is added to your current year's income, and the taxes are due with that year's return.
By planning carefully, however, you can minimize this tax bite. Let's say you receive a six-month severance package through October. Wait until January of the following year to tap your IRA. Adding those funds to your income might not push you into a higher tax bracket after all. During your start-up's first year you'll likely be earning less than you earned at your salaried job.
. . . . .
Don't be shy about using some of your retirement funds for what you really want out of life. Be confident and careful, but DO touch. What this money can do for your business might be as important as what it can do for your retirement.