Even employees who work for government employers, public schools and tax-exempt organizations might succumb to the entrepreneurial drive. When people leave the security of a steady paycheck to start their own business, they often have to tap into their retirement accounts to pay their personal expenses until they can generate a profit from their venture. There are a few ways you can use a 401(a) or 403(b) retirement account to fund a new business.
Bite the Bullet
The most immediate way of getting money to start a new business is by liquidating your retirement accounts. You can withdraw after leaving your employer, but if you’re younger than 59 and a half, you’ll have to pay early withdrawal penalties. Even if the extra 10 percent penalty doesn’t apply, you’ll owe tax on any untaxed money in the account. Both 401(a) and 403(b) accounts allow for pre-tax contributions, which could result in your entire withdrawal being taxable. Unlike your non-retirement investments, selling off investments in a qualified account produces ordinary income. Liquidating your retirement accounts could leave you with less than half of your account balance after paying federal and state taxes.
Borrow Against It
Retirement plan administrators often offer the ability to borrow against your qualified retirement plan. The interest rates are competitive, and repayments go back toward building your account balance. Most importantly for someone starting a new business, the loan isn’t contingent on passing a credit check or substantial underwriting because it’s guaranteed by your account balance. You must actively participate in the plan to take a loan, which can pose a problem if you have already left government work.
Rollover to Self-Employed Plan
Fortunately, you can work around the active participation requirement with relative ease. Regardless of how you organize your new business, you can establish a 401(k) plan with a minimum of one participant. Tax code allows you to move your vested balance in 401(a) and 403(b) retirement accounts into your new employer’s plan through trustee-to-trustee rollover. As your own employer, you’re free to establish a 401(k) plan through an administrator who offers plan loans and transfer over your former employer’s plan balances.
Taking a plan loan will incur interest charges on the outstanding balance of your loan. Most plan loans offer reasonable interest rates, which could be less than 10 percent annually. Because you’re borrowing the money for your business, any interest you pay likely qualifies as a business expense. Unlike the tax you owe on liquidating a retirement account, interest that qualifies as a business expense is tax deductible.
Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.