Although there are a number of companies currently promoting the idea of using your 401(k) plan to purchase a business, I remain steadfast in my claim that 401(k) money should NOT be used to buy a business, regardless of the circumstances. Buying a business is a huge risk, one that most people will never take. But there’s a difference between being a risk taker and a gunslinger hence the difference between those who don’t use their 401(k) in the purchase and those who do. Why with so much at risk including: a steady income, personal savings, your ability to borrow, and possibly even your home, would you add your retirement plan to the assets at risk?
Let’s consider the following scenario; you are middle aged, have a college degree from a highly regarded institution, a family, and a retirement plan. If you leave your corporate job to buy your own business and the absolute worst case scenario arises in which you are not successful, what have you lost? You still have your education, you still have your experience and hopefully you still have your family. This leaves you in virtually the same position as when you made the decision to leave the corporate world. If someone hired you into your old job without the experience you earned there, surely they will hire you now with your new experiences to boast. Who cares that your most recent venture was not the booming success that you had hoped. You saw an opportunity in the market, you analyzed the risks involved and you went for it. I have yet to see an employer that frowned upon these qualities in their employees. I am confident when I say that at worst you have lost a little bit of time. If you were to purchase the business discussed above by using funds from your retirement account, now what have you lost? Your retirement!
Now, rather than being just a few years behind the financial curve you are a whole working lifetime behind. Using retirement funds to purchase a business can at first seem like an attractive option as it is easy money to access, there are no early withdrawal penalties and you intend to realize a return greater than that of your current retirement account. Since the IRS requires that your new entity be structured as a C Corporation if you use retirement monies penalty free, every dollar you make will be double taxed, once at the entity level and once at the personal level. Uncle Sam may allow you to take it from your IRA or 401(k) without penalty but, rest assured they will get their money somehow. Now you are forced into an entity structure that increases your tax obligations and requires you to achieve a greater rate of return to justify the higher cost.
There are many other alternatives to using tax deferred monies to purchase a business, LOTS of them. Some lenders will even offer financing based on the value of your 401(k) and/or IRA while using your retirement account as collateral. They will require that the account not be actively traded and dictate the amount of risk (usually low) in the investments but they will not draw funds from the account unless you default on your obligation. Plus, you can choose an entity structure that will result in only a single taxable entity. There are an innumerable number of ways to finance a transaction that must be explored before considering your 401(k) or IRA as a viable option. If retirement accounts are your only option, it may be suggested that the risk could outweigh the reward.