How to Use a 401K to Fund a Start Up Business

Funding your small business with your 401(k) is a gamble.

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You have been investing into your 401(k) for years, and you’ve built up quite a nest egg. You've been running a little home business on the side and it’s finally starting to pay off. You’ve heard that you can draw upon that nest egg to turn this side business into a full-fledged operation. You can, but there is lot of red tape to cut through, and the Internal Revenue Service will scrutinize every move, so proceed with caution.

Small Business Structure

You must set up your small business as a C Corporation before you can fund it with your 401(k). You must incorporate your small business with your state, and state laws vary, so make sure you follow your state’s policies and procedures to apply for a C Corporate business structure. Generally speaking, however, you need to establish a board of directors and officers for your venture, obtain shareholders, file articles of incorporation and designate a resident agent for service of process.

401(k) Set-up

Your next step is to open a 401(k) plan for your small business -- oddly, you’re opening a 401(k) to fund your small business with a 401(k). “Inc.” magazine explains, “Specifically, what you want is a profit-sharing plan that allows 100 percent of the plan assets attributable to rollovers to be invested in employer stock. A 401(k) can be tailored to meet these needs,” making it the perfect avenue to roll over your current 401(k) monies into. Look into various investment firms to find the right 401(k) provider for your small business’ profit-sharing plan. Firms that have a proven track record housing small business 401(k) profit-sharing plans are a good place to start.

401(k) Transfer

Once you’ve set up your business’ 401(k) plan it’s time to roll over your personal 401(k) into the profit-sharing account. A direct transfer is probably your best bet -- a simple process where your old 401(k) provider transfers the money over to your new 401(k) provider. Once the money has been transferred between the 401(k) plans, invest it in your company’s stock. As “The Wall Street Journal” explains, “since the person is buying shares of his or her own business, he or she is effectively feeding it money.” Use the monies received from your corporation’s stock to fund your small business start-up costs.

Things to Think About

On paper, this seems simple enough, but there is a lot to consider. The IRS’ jury is still out on whether it considers this a “legal and procedural issue,” according to “The Wall Street Journal.” At publication date, it is legal, but the IRS may eventually rule against using 401(k) monies in this manner. Another consideration is your age. If you are under the age of 59 1/2, make certain you conduct the 401(k)-to-401(k) transfer within IRS regulations. Otherwise, you might face taxes and penalties in the process of funding your small business with your 401(k). Finally, funding your small business with your 401(k) is more complex than it sounds, and it is probably not wise to go this alone. Be prepared to pay for the expertise of tax planners and investment advisors to guide you along the way. It might also be wise to invest in a corporate attorney to ensure all bases are covered when starting your small business venture with your 401(k) plan.

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