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December 20, 2021 at 06:49 PM
What You Need to Know
- Clients with significant 401(k) balances may wish to explore the 401(k) loan option for short-term startup funding.
- If a startup is organized as a C corporation, the client can roll over retirement funds into its new 401(k).
- The client won’t incur any penalties or income tax liability when doing this rollover, but very specific rules apply.
The number of startup businesses in the U.S. grew significantly between 2019 and 2020, even as business operations across the nation shut down and implemented widespread layoffs at the height of the COVID-19 pandemic.
While it’s difficult to pinpoint the exact cause, startup business grew by 24% despite — or perhaps because of — the pandemic during this time. Many employees may have opted to start their own businesses to gain control over their earnings or because of limited employment opportunities.
Whatever the reason, these newly minted business owners often face the same problem: a need for funding. Often, the bulk of the client’s assets are invested in retirement accounts — and many of these entrepreneurs may not know that those retirement funds could provide a viable funding solution.
Business Funding From a Retirement Account: Traditional Options
Unfortunately, clients can’t use their personal self-directed IRAs to invest in their businesses. The prohibited transaction rules would prevent these clients from paying themselves a salary, because self-directed IRA owners can’t work for businesses the IRA has invested in.
Further, many clients would incur an early withdrawal penalty for traditional retirement account distributions that are taken before the client reaches age 59½. That 10% penalty applies on top of ordinary income tax on the distribution.
Clients with significant 401(k) balances may wish to explore the 401(k) loan option for short-term funding. Plan loans are both tax and penalty-free if structured properly.
On the other hand, the amount the client can borrow is limited to (1) the greater of $10,000 or half of the account balance, or (2) $50,000, whichever is less. (The loan amounts were expanded for 2020 in response to the COVID-19 pandemic.)
Generally, the loan balance must be repaid within five years, and payments must be made at least quarterly.
401(k) Rollover: A Nontraditional Option
There are, however, less traditional routes that can allow a new entrepreneur to use retirement funds to self-fund a business. If the client’s new business is organized as a C corporation, that C corporation is legally permitted to form a retirement plan and invest in its own company stock — called qualifying employer securities.
