Buying a business is not a simple (or low-cost) endeavor — it can take a lot of time and capital to complete the deal. You may be wary of dipping your toes into entrepreneurship because of the upfront costs and potentially going into debt. 

One of the biggest challenges entrepreneurs face is coming up with the money to finance a new business or buy an existing business. 

It is possible to purchase a business without incurring any debt at all, though it can take a long time to build up enough money to purchase a business outright. Maybe you’ve been setting aside money, but your savings aren’t enough. Or you’ve been weighing common options like crowdfunding or a business loan. 

Turns out, you have another option. It’s possible to free up large amounts of money from your current investments – making it much easier to start that new business venture - all through your 401(k).

We’ll take an in-depth look at how 401(k)s can be used to purchase and finance businesses. We'll explain how these plans work and give some advice on when and if it's right for your situation. 

What is 401k business financing?

401(k) Business financing is an option for entrepreneurs who want to access funds to buy a business without the burden of interest payments and late fees. You also won’t have to deal with a third party, like a bank. 

Your 401(k) or “retirement funds” can often be composed of pre-tax income contributions saved over time and be used by the owner (of the retirement plan) to purchase a business or franchise, without any tax liability. 

In some cases, like with a rollover for business startups (ROBS), it provides entrepreneurs with the ability to invest in their future ventures without paying penalties, taxes, or interest on the money used. With ROBS, the loan repayment terms are more agreeable than bank loans because the money being paid back is your own money that you have deferred from taxes until retirement.

Using a 401(k) for business financing is an attractive way for people to get an opportunity to become successful business owners.

How to use a 401k to buy a business

Financing a business can be a difficult endeavor, but leveraging your 401k to buy a business might be one of the smartest financing options you'll find. When considering using your 401(k) to finance a business deal, you generally have three options:

1. Use a rollover for business startups (ROBS)

2. Borrow against your retirement accounts 

3. Cash out your 401(k) account

Taking advantage of this business financing tool requires some financial due diligence, as it is an investment that should be taken seriously and one that comes with pros and cons. 

Utilize resources such as business brokers and other industry contacts to make the process easier and the business more successful. With careful consideration and planning, using your 401k to buy a business can potentially offer huge financial gains.

How a ROBS works 

For individuals interested in purchasing a business and using their 401(k) to do so, there is a program called Rollovers as Business Startups (ROBS). This program allows you to use the money in your retirement account, such as a 401(k), to purchase a business without having any tax liability. It is not a loan or a withdrawal, but a rollover from your retirement account into a new account. ROBS is a great alternative to get the funds to buy a new business without getting a small business loan or fundraising. 

With a ROBS, the funds are rolled over into a new corporation and used to finance the purchase of the business. The company then pays back these funds over time, providing you with capital for your business without needing to take out a loan or accruing any tax liability from using retirement savings. You also won’t need to pay any early withdrawal fees from your account.

ROBS is a good option for potential small business owners who plan to work full-time in the new business after purchase. You won’t qualify for a ROBS if you’re investing passively in a new business. Also, your business must be a C corporation to qualify. 

Some of the other benefits of using a ROBS are that you don’t need to spend any previous time in the business to qualify unlike what you may need for an SBA loan, and you get immediate access to debt-free funding. However, the downsides are some of the stricter qualifications — like that you have to be a C corporation and work full-time in the business — can make ROBS less ideal for some owners. You also run the risk of losing your retirement funds if your business fails, and there are annual requirements you must maintain to avoid taxes and fees. 

ROBS can be very complicated, and there are some risks associated with this type of financing, including potential fines and penalties if not done correctly, so it's important to understand the legal aspects of this program before taking advantage of it. It's also essential to have a plan for repaying the funds and budgeting for any expenses associated with running a business before you make the purchase.

How much of my 401k can I use for ROBS? 

The maximum amount that can be rolled over into a new account as part of ROBS is the lesser of $50,000 or half the total balance in your existing retirement account. So if you have $100,000 saved in your retirement account, you would be able to roll over up to $50,000. You must have at least $50,000 in your retirement account to qualify for a ROBS. 

Borrow against IRA

Another popular option for using retirement funds to finance a business is taking out a loan against an IRA. This type of borrowing allows you to use your existing retirement savings as collateral to borrow against and then pay back over time. 

Finally, you may also choose to combine both ROBS and IRA loans (or standard 401(k) loans in order to finance your business. This option allows you to access more capital while potentially reducing the associated risks. When considering this option, it's important to understand how each type of loan option works and what their repayment terms are in order to make an informed decision.

By understanding all of your options for using retirement funds to purchase a business, you'll be better equipped to make a decision that is right for you.

How borrowing against a 401(k) plan works

Borrowing against a 401(k) plan is another option for financing a business. This type of loan allows you to borrow up to 50% of your vested account balance, or $50,000 (whichever is lower). The funds borrowed can be used to purchase the business, and the money must then be paid back within five years with interest. Payments must be made quarterly. Additionally, if you don’t pay the loan back in time, you will be subject to taxes and penalties.

You can also borrow funds from your 401(k) for up to 60 days without penalty, as long as you pay back the funds in full at the end of the period. While you do have to pay interest on the loan, that interest payment will be reinvested back into your retirement account as a contribution. 

Some 401(k) plans will limit what part of your retirement account you can borrow (for example, if you’re allowed to withdraw employer contributions), or how much you can take out. 

Taking out a 401(k) loan is much less complex than a ROBS, and you have the added benefit of repaid interest being added back into your retirement account as a contribution. What’s more, you don’t have to be a C Corporation to take out a 401(k) loan.

This type of borrowing can be attractive because it allows you to access capital without having to pay taxes or interest on the funds. However, it's important to understand all of the risks associated with this type of loan before making a decision. You could face a high tax bill and fees if you don’t repay the money. 

Additionally, it's important to have a solid repayment and business management plan in place before taking this option.

How ‘borrowing’ against a traditional IRA works

You also choose to “borrow” against a traditional IRA. This process allows you to withdraw money from the account and use it for business purposes without incurring any taxes or penalties — but it’s different from a 401(k) loan. It’s considered like a short-term loan, or that you’re just borrowing from the account. The amount you can withdraw is limited to the amount of your contributions plus any earnings on those contributions. 

You can borrow funds from your IRA for up to 60 days without penalty — if you don’t pay it back, it’ll get taxed as a withdrawal with a 10% penalty. You’re only allowed to borrow from your IRA once per year. 

This type of financing can be attractive for those who are looking for quick access to capital without any interest payments. However, it is important to understand the associated risks and costs before making a decision. 

Cash out 401(k)

You may also choose to cash out a 401(k) or traditional IRA in order to finance your business. This option involves liquidating the entire account and using the proceeds for business-related expenses. This type of withdrawal triggers taxes and penalties, so it’s important to consider all of your options before you consider cashing out. 

There are some circumstances where you can withdraw from your 401(k) without facing taxes or fees, known as a qualified distribution. If you’re below age 59 ½, any nonqualified distribution will be taxed and have a 10% penalty.  

Qualified distributions include money used for higher education expenses, first-time homebuyer charges (up to $10,000), and unreimbursed medical expenses. 

Implications of withdrawing from a traditional 401(k) or IRA 

When withdrawing funds from a traditional 401(k) or traditional IRA, there are certain implications to consider. It can lead to significant taxes and penalties because the money used to fund a traditional IRA or 401(k) is with pre-tax income. 

First, you will owe taxes and penalties on the withdrawn funds unless you repay the loan within 60 days. Most plans will withhold 20% immediately for federal taxes and charge you 10% in penalties, which means you’ll lose 30% immediately. 

Withdrawing funds from a traditional 401(k) or traditional IRA can reduce your retirement savings, which may leave you with less money in the future. 

Implications of withdrawing from a roth IRA or 401(k)

When withdrawing funds from a Roth IRA or Roth 401(k), the implications are different. Withdrawals from these accounts are not subject to taxes or penalties, assuming you have had the account for at least five years and haven’t already withdrawn more than your contributions. However, withdrawals will also reduce your retirement savings, which can hinder your future financial health. 

All contributions with a Roth account are funded with post-tax dollars, which means they can be withdrawn tax-free, as long as you are 59 ½ and the plan is at least five years old. If not, you’ll face a 10% penalty. You cannot withdraw earnings on your contributions tax-free until you’re 59 ½. 

Some of the benefits of simply withdrawing from an account include the ability to get access to a larger sum of money (without worrying about repayment), and that you can use the money for both personal and business expenses. The downsides are the potential tax and penalty implications — and the possibility you could be placed in a higher tax bracket and face even higher income taxes. 

Overall, there are several options for using retirement funds to finance a business. With all of these options, it’s very important to understand the associated risks and costs as well as create a solid repayment and business management plan. With careful consideration and research, you can make the right decision when it comes to investing your retirement savings in a business.

Legality and tax implications 

401(k) business financing is becoming an increasingly attractive way for entrepreneurs to fund their startups. It offers many advantages, such as allowing you to draw from your personal retirement savings in order to invest in your business - leading many small business owners to consider it as a viable option. 

However, you must also be mindful of the legal and tax implications associated with this method of financing. We’ve covered just some of the implications above, but the entire process can be very complex and it can be sometimes difficult to know if your withdrawal will trigger taxes or penalties. 

By working with a financial professional who specializes in 401K loans and rollovers, you can rest assured that regulations are being met while ensuring that any tax liabilities triggered by these decisions are properly taken into consideration. With informed decision-making, you can use your 401K to give your business the boost it needs without running afoul of legal and tax law issues.

Can I use my 401k to buy a business without penalty?

The short answer is yes, you can use your 401k to buy a business without penalty as long as all of the rules are followed. However, several considerations must be made for this to be done properly and legally. 

It’s recommended to work with a financial professional who specializes in 401K loans and rollovers to ensure that the proper steps are taken. This includes making sure that you pay any taxes and penalties due on the withdrawal, as well as setting up a repayment plan for the loaned funds. 

It’s also important to make sure that you have a solid business management plan in place so that your business will be successful and able to repay the loan. It’s really important to consider all of the associated risks and costs before making a decision. With careful consideration and research, you can use your 401(k) to finance your business without penalty.

Understanding eligibility

To use your 401(k) to purchase a business, you must first meet certain eligibility requirements. For Roth accounts, you need to have had the account for at least five years. For any withdrawal or loan, you need to have an approved plan document in place, and that you follow all relevant IRS guidelines. 

You should be aware that there are a variety of fees and taxes associated with withdrawing from your 401(k) or IRA, which should all be taken into consideration when making a decision. If you fail to repay the loan within the allotted time frame, the entire withdrawal amount will become subject to taxes and penalties. You may also put your retirement in jeopardy if you’re unable to pay back your loan. Working with a financial professional who specializes in 401(k) business financing can help you understand these requirements. Baton can connect you with the right professional to walk you through your options. 

Alternatives to a 401(k) loan to start a business 

Starting a business can be a difficult endeavor, and sometimes it requires more financial resources than one person may have available. A 401(k) loan can offer entrepreneurs the resources they need to get their business up and running, but, as we mentioned before, that comes with its own set of risks. For those wary of borrowing against their retirement accounts, there are plenty of options to consider. 

Whichever option you choose, sufficient research must be done beforehand so that you make an informed decision about which path will best suit your needs.

Business loans 

Business loans from banks and alternative lenders are great, standard options for entrepreneurs who need capital to get their business off the ground. 

Many financial institutions have loan programs specifically designed with small businesses in mind, so it is important to research your options thoroughly before making a decision. Make sure you understand the full amount that needs to be repaid, including interest rate and payment terms. Additionally, you should be aware that some lenders may require collateral or a personal guarantee from the borrower to secure the loan. 

Home equity loan or home equity line of credit 

If you own a home, you may be able to use your home equity to finance a business. A home equity loan allows you to borrow against the current market value of your house, while a home equity line of credit (HELOC) provides access to funds over time as needed. Both of these options are typically more favorable than traditional loans due to their lower interest rates and longer repayment terms. However, it is important to keep in mind that if you fail to repay the loan, your home could be at risk of foreclosure.

Personal loan 

A personal loan is another option for those looking to finance a business without taking out a 401(k) loan. Personal loans are available from banks, credit unions, and online lenders and typically require no collateral. If you have a strong credit score and income, this may be a solid option for you. 

However, the interest rates on these loans can be higher than those of traditional business loans, so it is important to thoroughly research the terms before applying. 

Crowdfunding 

Crowdfunding sites are also becoming increasingly popular for entrepreneurs looking to start a business without taking out a loan. Through crowdfunding platforms, you can raise money from a large number of individuals, often with no strings attached. The success of your fundraising campaign will depend largely on the amount and quality of research you put into it, so make sure to thoroughly plan ahead before launching. 

Should you use a 401 to buy a business?

When it comes to purchasing an existing business, taking out a loan from your 401(k) may be a great option for some entrepreneurs. However, this should not be done without thorough research and consideration of the risks involved. Taking money out of a retirement account can impact your future financial security, so you should make sure that you understand the full consequences of this decision before going down this path. 

It’s important to make sure that you have a detailed plan in place for how you intend to manage and grow the business after purchase. Taking out a 401(k) loan to buy an existing business can be a smart move for those who have done their research and are confident that they can make it a success. However, for those who are unsure or unprepared, this may not be the best option.

Overall, there are several financing options available to entrepreneurs looking to start a business without taking out a loan. From tapping into personal savings, and utilizing equity in your home to applying for business loans or crowdfunding, there is a wide range of possibilities.

How Baton can help 

If you’re thinking about dipping your toes into entrepreneurship, you probably have some questions. That’s why we recommend working with a team of professionals, including tax professionals, who can answer these questions and offer advice throughout the entire process. At Baton, we help business owners and buyers navigate business sales. We assist owners in identifying how much their business is worth and support them throughout their journey to either grow or sell their business. Get started with Baton today!

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