Should You Use Retirement Funds to Fund a Business?

Andy Anderson

fund businessEver since the credit markets got tighter and banks made it harder to get small business loans, many would-be entrepreneurs have looked to alternative lending sources to fund their new ventures. Without established business credit, it can be difficult for an individual to pursue that dream of business ownership, but it doesn't have to be that way. If you are unable to obtain seller-financing for an existing business or the bank's terms are just too costly, this is no reason to throw in the towel. Many new ventures have been launched through "self-funded" loans.

Why not invest in your own business?

As individual investors, we tend to invest in other companies anyway. Whether you buy individual stocks or mutual fund shares, your retirement funds are being used to fund a business, so why not invest in something you have more control over? But is it really a good idea to use your own retirement funds to finance a new venture?

The decision about whether or not to borrow from your 401K will depend on the type of business you are financing. One reason it can work is that the funds are your own, so you will be more likely to spend them wisely. Venture capitalists invest in businesses all the time, and while it can be risky they tend to generate higher overall returns than traditional stock market investors. Think of it this way; when you bet on a stock you are essentially betting that the CEO and executive management will run the venture wisely, that they will make wise decisions that will pay off handsomely down the road. In the same fashion, if you truly believe in your own business concept and your own ability to make a profit, think about how much more your return on investment could be. You could double – or even triple – your investment in less than five years, and this certainly beats the odds of beating the stock market indexes.

Should you look to retirement funds first?

Choosing which funding source is best will depend on the choices you have available. If an SBA loan is out of the question and seller financing is unavailable, then it's probably best to look at your own resources. Self-financing may seem risky, but it's not the worst way to raise capital for your business.

One thing that many new business owners don't realize is that larger companies have been doing this for years. Whenever a company offers stock options to employees, they are taking advantage of an IRs code which allows employees to invest retirement funds with their own company's stocks. And while most employers offer some type of self-funded retirement account, the responsibility of managing that money has become the sole responsibility of the employees.

Can any retirement account be used to fund a business?

When considering how to properly use retirement accounts, it is important to consider certain factors. For example, can the retirement funds currently held by your employer be rolled into your new business's retirement plan? The best types of plans for funding a business venture include: IRAs, followed by 401 (k) plans, 403 (b) plans, 457 plans, SEPs, annuity plans and profit-sharing plans.

How can you put your retirement assets to work in your new venture?

  • Form a new C-Corp corporation as your business structure, per the ERISA and IRS guidelines. Keep in mind that a Partnership, LLC or S Corporation will not meet the funding requirements.
  • Adopt a company retirement plan for the new corporation that allows one to investment in the corporation.
  • Roll your current retirement plan(s) over to the new plan, which allows you to avoid any penalties or taxes.
  • Choose the stock of the new business as the investment choice within the new retirement plan, which will give the new corporation enough capital to fund an expansion without adding debt.
  • When structured properly, your new retirement plan will hold your company's stock on its balance sheet. This allows any dividends to be invested back into the plan, and/or shares to be bought back later at a higher value.

Why should you self-fund your new business?

  • The funds you are using are already yours, so you won't need anyone else's approval.
  • The new company will not assume any debt, since this type of funding is not considered a loan.
  • You will not need to pay any interest, plus tax penalties and distribution fees will not be added because you are essentially buying a stock that invests in your own company.
  • There is no need for collateral, nor is there a penalty for prepayment.
  • Since you are not personally liable for the funds, this type of funding won't affect your personal credit score.
  • Any profits can be invested, tax-free, into your business or pension plan.

Not only will this approach reduce your business overhead; it will help you to more aggressively grow your retirement assets. Rather than mailing payments to an anonymous lender, the money can be used to purchase equipment, buy advertising and fund other growth initiatives that will ultimately make the business more profitable.

Is it risky to fund a business with retirement assets?

One of the risks involved with using this strategy is the possibility that the business will fail and your retirement assets will be lost. However, these risks can be mitigated by doing feasibility studies and conducting proper research before getting started. Proper management of the business is another way to ensure success. This may mean making the appropriate changes or tweaking what isn't working, with the goal of making the business more profitable.

Photo Courtesy of Suphakit73 / FreeDigitalPhotos.net

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