If you’re interested in purchasing a small business, one of the first things you have to determine is how you’ll pay for it. Most prospective business owners today do not have all of the capital saved for purchasing a business and must obtain funds from elsewhere to manage the purchase. So where will you get the money?
There are many ways of funding the purchase of a small business, and one way that many buyers are managing to secure funds is through their 401(k) retirement plans. Opinions on how wise a decision this is vary widely, so here is a quick look at the topic.
How Do You Use a 401(k) to Buy a Small Business?
There are three main ways that you can use your 401(k) to buy a small business:
- 1. If you are over the age of 59 ½, you can withdraw the money from your 401(k) and use it to fund your business. This option will require you to pay taxes on the money, but you will have the freedom to use it as you wish.
- If you are under age 59 ½, you can start a C-corporation and work with a securities broker to have a 401(k) plan attached to the C-corp. Then, you can do a rollover of the funds from your existing 401(k) to the new one. After that, you’ll use the 401(k) to buy shares of the company, thereby funding it. This option should be done with the help of a tax professional. If it is not done correctly, you could face steep fees and tax penalties. You will also want to keep the tax professional under your payroll on an ongoing basis, as paperwork will need to be filed regularly to keep this transaction legal.
- If you are still employed and under age 59 ½, you can take out a loan using your 401(k) as collateral. This will allow you to maintain your retirement account and obtain financing up to a certain percentage of the value of the account. You can only maintain this type of loan until you terminate employment, so it might not be the right fit if you plan to leave your job as soon as you purchase your business.
The Benefits of Using a 401(k) to Buy a Business
There are some distinctive benefits to buying a business with a 401(k), including:
– Potentially tax free money: If you use the second method listed above, you’ll be purchasing your business with tax free money.
– No or Low Financing Costs: If you use method one or two to purchase your business, you will be able to avoid getting a loan, so you won’t have interest to pay. Method three may result in a much lower interest rate than a small business loan depending on the type of business you are purchasing and your overall financial picture.
– Access to Funds: Getting financing for a small business is not easy for many prospective buyers. Using methods 1 or 2 will guarantee you financing, while it will likely be easier to get a loan using method 3 than it will be to get an unsecured small business loan.
The Downsides of Using a 401(k) to Buy a Business
There are two big drawbacks to using a 401(k) to buy a business:
1. Risk – Your retirement fund is meant to help you manage your expenses during retirement. While 401(k) accounts are open to some risk, purchasing a business with the money may pose a much higher risk for loss than the types of products in which you are currently invested. If you are nearing retirement age, the need for access to retirement funds may make the risk unwise; however, if you are still some time away from retirement, it may be smart to take the risk now.
2. Tax consequences – As mentioned earlier, if funds from a 401(k) are not used correctly, you could be in for a nasty surprise from the IRS. This is why it can’t be stressed enough that you should hire a tax professional to assist you with the process.
Should You Use Your 401(k) to Buy a Business?
If you’re interested in buying an online small business, we can help you explore your financing options including how much capital is likely needed. This information can help you decide whether using your 401(k) to become a business owner is the right choice for your financial needs.