401(k) Tips

How to use a 401(k) to buy a business

Learn how you can use your 401(k) to buy a business and what the pros and cons are to each option.

2 min read

“It's a joke that I have decent money in 401(k)s, but I can’t use it to pay off my credit debt.” - Linda.

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Oftentimes the stock market is too volatile for some individuals to feel comfortable investing their retirement savings into stocks. If this is the case, you may be looking for other ways to invest your retirement savings to make that money grow, which has led you to consider buying a new business. Or perhaps the opportunity for a new business venture has opened up, but you are short on cash. No matter the situation, it is important to know how to use your 401(k) to buy a business. 

Before deciding to make such a purchase, it is important to consider the risks. If the business fails, you will not only lose your business assets, but also most or all of your retirement savings. However, if you decide that your 401(k) money would be better used for a business, then you have three options. You can take an early distribution, borrow against your 401(k), or you can choose to roll the money over into a business owner's retirement savings account. 

Early Distribution 

Taking an early distribution should be your last resort. This path will still get you money to purchase a business, but it is subject to the largest amount of fees and taxes. 

Any withdrawals made before you are 59 ½ years-old are considered early withdrawals and are subject to a 10% penalty fee and federal income tax. This means that a large portion of your 401(k) capital will be eaten up by taxes and fees, which could affect how much cash you have left to purchase the business with. 

If you have to use this option, simply contact your plan’s provider and request a distribution. You can request to have the full amount in the 401(k)-account distributed or you can request only the amount that you need to purchase the business. 

Borrow Against Your 401(k)

A better option may be to borrow against your 401(k) by taking out a 401(k) loan. Not all 401(k) plans allow 401(k) loans, so you will have to contact your plan provider to ask if this option is available to you. 

If your plan does allow you to borrow against your 401(k), you are permitted to borrow half of the amount in your 401(k) up to $50,000. This is usually a more favorable option because loans are not subject to the 10% penalty fee, nor are they subject to income taxes.  

It is important to remember that you will have to repay the loan plus interest. Usually, 401(k) loans must be repaid in five years. If you do not repay the loan in the five-year period, it will be considered a taxable withdrawal, which means it will then be subject to income tax plus the 10% early withdrawal fee. Many plans do not allow you to make any contributions to your 401(k) until the loan is fully repaid, so this may be a factor to consider if you plan to continue to contribute to your 401(k) after purchasing your business. 

Owners Retirement Savings Account 

The last option, and probably the best option, is to roll the money over into a Business Owners Retirement Savings Account. A business owner's retirement savings account is a specialized individual retirement account (IRA) which allows the IRA to buy stock in a personal corporation. To do this, you will need to find a Certified Personal Accountant (CPA) to act as the plan administrator. 

Once you open this account, you can contact your 401(k) plan’s provider to request that your funds be rolled over directly into the business owner's retirement savings account. It is important to make sure it is a direct rollover so that the funds are not subject to any taxes.

Once this is done, you can open a personal corporation in your state. The CPA can then use the funds in the IRA to purchase stock in your personal corporation. When stock in your corporation is purchased, the money will go into the business’s account. You can then use the money in the business’s account to purchase a business.

Although this option is the most complicated choice, this is the best way to access your 401(k) funds without having to pay any penalties or repay the money to your 401(k) account. Regardless of which option you choose, you should consider the costs and risks of each option to make sure that you find the best way to reinvest your retirement savings into a new business.