As a business owner, your most valuable assets aren’t the machinery, or the raw material. It is your employees. Your employees work with a deep rooted interest of making not just profits but a name and great relationships in the market for your business.
An employer takes complete responsibility for their employees’ salaries and the various components attached to them. Whether you talk of the salary and wages, retirement plan, health insurance, long-term initiatives, or bonuses and other investments, all of such components are taken care of by the employer. So, what if your employee needs money urgently? There should be a way of helping them while also not impacting the cash reserves of your company?
Many organizations are now taking the option of 401 (k) loans seriously. They offer their employees the option of borrowing from their retirement savings in case an emergency comes up.
Apart from that, the 401 (k) loan is now widely used by startups and small companies for establishing their businesses. This process is popularly known as a 401 (k) loan for business financing. The process enables you to borrow from your retirement funds so you can finance your business or a startup. The method is gaining popularity because of the multiple benefits it offers.
But before you include this option in your company’s profile or decide to withdraw from your 401 (k), it’s better to learn the various aspects of 401 (k) loans, factors affecting them, the benefits, procedure, eligibility criteria, etc. We have included everything in this article that you need to know and understand about 401 (k) loan.
What will you find in this article –
- What is a 401(k) loan?
- When Should You Borrow from Your 401 (k) Funds
- About ROBS
- How Does 401(k) Business Financing Work?
- What are the Benefits of 401(k) Business Financing?
- What Makes the 401 (k) Business Financing a Better Funding Option Than Most Other Alternatives?
- What Happens When You Can’t Pay the Borrowed Money Back?
- What are the Alternatives to 401 (k) Business Financing?
- Are There Any Risks Involved With the 401 (k) Business Financing?
- When Can You Not Use The 401 (k) Funds for Business Financing?
- What Business is Eligible for ROBS?
- Common Myths About ROBS
- Key Takeaways
What is a 401(k) loan?
To make money usage more effective and ensure a peaceful retirement, companies provide retirement funds to their employees. This enables security and allows people to have some money with them when they finally retire. But one can now borrow money from one’s retirement funds as a loan. The amount you can borrow depends on your company or organization’s plan. But you can withdraw as much as 50% of the total savings. There is a $50,000 cap for a period of 12 months.
The money needs to be paid back within 5 years of borrowing it along with the applicable interest. Married people would need the consent of their partner or spouse before the loan is approved. While borrowing from your retirement funds, you sign an agreement mentioning the principal, duration of the loan, interest rate, and other terms and conditions. 401 (k) loans are often easily approved when compared with other types of loans from banks and lenders. It is often believed that when you need a major amount of money in a shorter period, 401 (k) loans come in handy. One should always remember that certain conditions and terms should be met before you actually receive the loan.
When Should You Borrow from Your 401 (k) Funds
Professionals and experts genuinely believe that acquiring a loan from your retirement funds for an urgent short-term requirement is an apt idea. The duration can be a year or less. The option is considered beneficial because the interest rate here is not very high as compared to bank loans. It is one of the easiest and quickest ways of getting cash on an urgent basis. Another reason why the 401 (k) funds are admired is that there is no involvement of taxation and it also doesn’t affect your credit score.
Technically, 401 (k) loans are not ‘loans’ in a real sense because there is no involvement of a lender, you are basically borrowing from yourself. Also, whatever interest you will be paying, will go to your own retirement account. Getting a 401 (k) loan does not need you to fill out long application forms and your credit score is also not checked for the same.
Another thing that you can do with your retirement funds is you can finance your business. Does it sound too good to be true? Sure, it does! But that’s not a joke. You can utilize your retirement funds and use them as a loan to finance your company or new business. Abbreviated for Rollovers as Business Startups. This is yet another method of withdrawing from your 401 (k). The major difference between a ROBS and a normal 401 (k) is you enjoy some level of autonomy. You don’t have to worry about being employed to utilize this financing method. ROBS is an efficient and effective way of financing your new business without worrying about any collateral, funding, or credit card loan.
Another key factor that differentiates ROBS from the 401 (k) loan is the amount that you can borrow. For a 401 (k) USD 50,000 is the maximum amount while the same is the minimum cap for ROBS. So, if you are planning on going for the latter option, your retirement funds should have more than USD 50,000.
How Does 401(k) Business Financing Work?
401(k) business loans can be a boon for new business owners aiming to set up a new business. Taking loans from banks and other ledgers means borrowing money at hefty interest rates and you have to pay a good amount every month as an EMI or instalment. This leads to an additional burden on you when you have to manage the other expenses of your company. A small firm, especially a start-up, requires money to operate properly, especially during the initial days. This is where your 401 (k) loan can help you.
Setting up the 401 (k) loan can be complicated so as to ensure that a taxable distribution n is not triggered. To save yourself from such a situation, you can hire a trained expert who has immense knowledge of 401 (k) loans. Here are the detailed steps explaining the working of a 401 (k) loan for business financing:
Step 1 - A C corporation needs to be created.
Step 2 - Then you have to set up a retirement funding loan plan for the newly created C-Corporation. After that, a custodian is selected.
Step 3 -Transfer your current 401 (k) and other pre-tax retirement assets to the newly made retirement fund loan plan. This ensures that no taxable distribution is added or initiated in your name.
Step 4 - This new 401 (k) plan can now buy stock in your C corporation.
Step 5 - Now, the money from this stock can be used to fund and initiate your company or business.
More and more people are switching to this alternative because it is hassle-free, no hefty interest and instalments are involved, and you are basically borrowing from your funds. This is why most new and small businesses find a safe haven in 401 (k) loans. Despite these easy and smooth factors, you are advised to pay back the amount on time, i.e. within 5 years in most cases.
What are the Benefits of 401(k) Business Financing?
Not many business owners are aware of this option, though it is gaining popularity with time, the awareness is not that high. But the 401 (k) loan is a great way of funding your business. It doesn’t affect your credit score and that is one of the major advantages. You also don’t fall into debt with a retirement funding loan because it is your money after all. Here are some additional advantages that make the 401 (k) loans suitable for funding businesses:
It is in Your Control
By investing in stocks in your own company, you are actually investing in your own work. You have more control over that money knowing that it has not been borrowed from a bank or lender.
Forget About Heavy Interests
Since you are taking money from your retirement funds, there is no need to make heavy interest payments. You can save the first part of your business’s money and repay the debt. No hassle of interests.
As per the ROBS structure, you can borrow from your retirement funds without even triggering any taxable distribution. There will be no tax penalty because of the early withdrawal.
No Collateral for the Loan
Normally, you need collateral for taking a loan from the bank. But if you are borrowing from your retirement funds, all you need is about $50,000 and you qualify for that loan.
An Option for the Down Payment
Let’s say you don’t have enough money in your retirement funds, you can still use that amount for making the down payment on a Small Business Administration loan that is valued more than the amount in your 401 (k) funds.
Participation of Employees
There is something called an employer-sponsored 401 (k) loan program. You can provide participation to your employees if both parties agree to it. This is because the ROBS funding structure makes the establishment of a 401 (k) plan mandatory.
How Much Does ROBS Cost?
Studies done on various suppliers revealed that a ROBS transaction for the setup can cost between $4,000 and $5,000. Additionally, there are continuous monthly payments for support and upkeep services like IRS reporting, checking eligibility, and plan reconciliation. These costs could be between $75 and $140 each month. Some service providers charge a base monthly fee up to a certain cap, and then there is an extra fee for each additional employee.
Since a ROBS is not a startup business loan, there is no debt or interest to repay. A ROBS does, however, come with some expenses. You could hire an accountant and an attorney to assist you set up and managing your 401 (k) loan, but a ROBS provider would be a better choice because they are more familiar with the specifics of IRS laws.
The average cost to set up a ROBS plan is $5,000. These funds cannot be obtained from the funds you are spending for the ROBS; they must be paid out-of-pocket. The creation of the retirement plan, the establishment of the C-corp, and the filing of papers with the IRS are typically included in the startup expenses.
Ongoing Maintenance Costs
The average ROBS plan has monthly management fees of about $130, but these costs can go up depending on how many employees are utilizing your company's retirement plan. In order to comply with 401(k) rollover regulations, maintenance fees also cover alerting and educating qualified employees about the company's retirement plan as well as filing documentation with the IRS. Depending on the ROBS provider, these expenses might be charged annually rather than monthly, but they cannot be covered by the retirement plan, just like the startup fee.
What Makes the 401 (k) Business Financing a Better Funding Option Than Most Other Alternatives?
There is a reason behind business owners’ fondness for 401 (k) business financing. Here is what makes this option different and better than other loans:
Regular Payments Required
You don’t have to make regular payments in case of 401 (k) business financing. But these payments are mandatory for credit card loans, business loans, unsecured loans, etc.
A company owner opting for 401 (k) business financing does not need to make interest payments. While the other loan options require you to pay interest with the loan.
Since you are borrowing from your own retirement funds, no credit checks are done. Also, 401 (k) business financing does not affect your credit score.
There is no need for any down payment while taking a 401 (k) business financing because the money you are borrowing is your own. No bank or lender is lending you the money.
The Eligibility Criteria
While you know enough about the loan now, you also need to know the eligibility criteria of how you can take the loan.
- Only selected plans allow you to take a 401 (k) loan. These include profit-sharing loans, 401 (k), 403 (b), and 457 (b) plans. So, if you are planning on going forward with the 401 (k) loan, it is best to consult your administrator and know every minute detail about it.
- You should be more than 21 years of age to qualify for the 401 (k) plan.
- You should be in the job or service for at least a year.
- Your retirement fund should have USD 50,000 or more.
What Happens When You Can’t Pay the Borrowed Money Back?
No matter how beneficial something is, it is always wise to take into account the worst-case scenarios. “What if I can’t pay the money back?” is a genuine question that must be popping into your mind. If you miss various instalments of the loan, it will automatically go into the default section. As a result of which, if you are under 59.5 years of age, the withdrawn money will be treated as a withdrawal and you will have to pay taxes for it. You will also be penalized with a 10% withdrawal penalty. Despite this, the administrator will not report it to the credit bureau because 401 (k) loans do not impact your credit score.
What are the Alternatives to 401 (k) Business Financing?
Despite being a great option, it is recommended that you also explore other financing options before settling on 401 (k) business financing. Though there are not many options left, business loans and 0% intro APR business credit cards are considered good alternatives to 401 (k) business financing.
It is understandable that getting a business loan can be complex and frustrating. Your credit score may not be as good, the bank may have rejected your application, you may be apprehensive about the loan repayment, etc. But there is still a fair chance for your business loan to get approved. Invoice financing, equipment financing, short-term online loan, business line of credit, etc are some of the options you can explore under the ambit of business loans. You can also find business startup loans for newly launched companies.
0% Intro APR Business Credit Cards
This option is more viable for business owners who don’t need a high amount. Business credit cards make a perfect fit in such conditions when you want a small loan. However, for a business credit card loan, you need to have an impressive credit score. The better the score, the higher will be the benefits of the card. The 0% APR option is offered by many credit card administrators, which gives you an additional advantage of not paying any interest for the first several months on the expenses.
Are There Any Risks Involved With the 401 (k) Business Financing?
You should go for the 401 (k) business financing options when you are entirely confident of your abilities and have enough resources to kickstart your business. You should also make sure that you have enough money in your retirement funds so that not all the savings are exhausted. There are certain consequences of using your retirement funds for financing your business or using it to set up a new company. Before you make up your mind about borrowing the money, here are some factors you need to take into account. It is best to go through them carefully as you finalize your decision.
No Changing of Job for the Duration of the Loan
Once you validate the 401 (k) loan, you can’t switch to a new job till the entire amount is paid back. If you somehow change your job or lose your current job, you will have to repay the entire debt all over again.
No Contributions to Your 401 (k)
Experts have found out that a major portion of people who borrow money from their retirement funds stop contributing to it till the loan amount is paid. Also, many administrators themselves rule out the contributions for the duration of the loan.
Loaned Money is Subject to Two Taxes
You receive salaries, pay taxes on them, and utilize the money left over after taxes to pay back the loan. You pay taxes once more in retirement, but this time on money that has been withdrawn. Double the tax is quite costly if you belong inside the federal tax level of 25%.
When Can You Not Use The 401 (k) Funds for Business Financing?
With a ROBS, the majority of operational business expenses are permitted and almost very few are prohibited. These include payroll costs, lease, and mortgage payments, and other regular outlays the company makes. The prohibited expenses include:
The IRS states that the property used for commercial purposes may not be used for personal purposes. This would apply to any company-owned vehicles or real properties. A 15% tax is also levied on every transaction where an owner or member of their family receives business property.
Direct Payment to the Owner
To qualify for a ROBS, a business owner must work actively for that business. You cannot, however, pay yourself a wage that is deemed inappropriate for either the position you hold or the income of the company.
What Business is Eligible for ROBS?
If you are willing to get the ROBS funding, there are certain criteria that need to be met. Laws in the US expect you to adhere to some specific conditions in terms of the business you aim to start. Here are the details that can be helpful to you:
The Company Must be Legal Under Federal Law
Any company receiving ROBS funding needs to be federally compliant and have a U.S. location. Pot stores are not eligible for ROBS since they are not federally authorized, even in places where they are allowed. Additionally, even if the owner lives in the United States, companies that operate abroad are ineligible.
The Company Must be an Operating Business
An entity that is primarily involved in the sale or exchange of a good or service rather than only the investment of cash is referred to as an operating firm. This isn't a concern for the majority of business owners. However, there are situations when people want to invest in a hobby.
A C Corporation Must Own the Company
You must set up a new C corporation to complete the ROBS process. A C corporation must be the parent firm. As long as the parent firm is a C corporation, you may run the business as an LLC or a sole proprietorship. In other words, all funds pass via the C corporation for tax reasons.
You Have to be a Real Employee of the Company
You must actively work for your company and not just simply invest in it or own stock. When someone wishes to use retirement assets to purchase a business for a friend or family member, that person frequently makes a mistake. You cannot buy a firm via ROBS and then leave it afterward.
Common Myths About ROBS
The market is full of people with different perspectives on Rollovers for business startups. There is a lot of misinformation on the procedure that often scares people off before they even try to get the loan. So, these common myths are to be busted here:
ROBS Allows You to Avoid Tax
There is no method to evade taxes by using ROBS to finance your franchise or business. In 1974, the Employee Retirement Income Securities Act was passed by Congress (ERISA). Employees have another option for amassing retirement savings thanks to ERISA and specific provisions of the Internal Revenue Code.
ROBS is a Loan
People often consider ROBS a loan but it’s not. It is a completely debt-free kind of financing. You can use this funding option to put retirement money toward a franchise or new business. Being able to start a business without having to pay loan payments or interest is one of the main advantages of ROBS. Four years later, 81 percent of Guidant clients who utilize ROBS are still operating. That is almost twice as likely for small business owners to succeed as when they rely solely on loan funding.
Self-Directed IRAs and ROBS are Similar
Although both self-directed IRAs (SDIRAs) and ROBS are used to finance businesses, there are significant differences between the two. Users of an SDIRA are not permitted to work for the company they invest in or receive a salary, but ROBS users are required to do both. Unrelated business income tax, or UBIT, may apply to the amount invested through an SDIRA. UBIT is a tax that can become extremely expensive, very fast.
Are ROBS and 401 (k) loans the same?
ROBS, which stands for Rollover as Business Startup is a procedure that allows you to take some amount from your retirement funds, i.e. from your 401 (k) account. This is the only difference between the two terms.
Is the ROBS process or borrowing from the 401 (k) account risky?
You need to have a clear plan for the business you are going to set up using your retirement funds. Though there are no major consequences because you basically borrow from your retirement funds, which means there is no involvement of a bank or lender, you still have to be careful. If you are confident with your skills and resources, then ROBS can offer additional help to you.
How long is the process of 401 (k) funds for business financing?
The duration of the process depends majorly on the ROBS provider you hire. It can take roughly 2 to 4 weeks for the entire procedure to complete.
Who can help with setting up ROBS?
Setting up the ROBS is a little complicated as it involves hefty documentation and other work. It is advised that you consult an experienced professional for this work. They will help you understand every aspect of it in detail and this way, you will have a clearer picture of everything. The help of an expert is required so you can stay complied with the IRS and DOL principles.
What if I can’t pay the amount back on time?
If you default on your repayment obligations, the remaining loan sum is seen as a withdrawal. Taxes on income are due on the complete amount and you will have to pay them. Additionally, you can be responsible for the 10% early withdrawal penalty if you're under the age of 59.5 years. If this happens, your entire savings are heavily affected.
How much time do I get to pay the loan?
Normally, you are given 5 years to pay the money back. But if you somehow buy your principal residence with that money, you get 25 years to repay the loan.
How much money can I borrow from my 401 (k)?
The maximum amount you can borrow is USD 50,000 or half the amount you have invested in the plan.
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With many advantages, 401 (k) loans for business financing have proved to deliver satisfactory results. A lack of funding, collateral, fear of loan repayment, and high-interest rates often lead to people not following their passion, which ultimately forces them to give up on their dreams. This is where the 401 (k) loan enters the game. If utilized properly with a carefully planned strategy, there are good chances for your business to flourish.
You can borrow USD 50,000 for 12 months from your 401 (k) account. So, make sure that you have more than the specified amount in your retirement funds. You will have a total of 5 years to repay the amount and if the loan isn’t settled by then, it will be deemed defaulted. A major consequence of which will be the entire loan amount will be considered an early withdrawal and you will be liable to pay tax on that money.
401 (k) loans for business financing are preferred by business owners over other loan options because there is no involvement of high-interest rates and your credit score is not affected by the loan. However, you are advised to hire a professional expert while filing for 401 (k).