401k Withdrawal to Start a Business: Your Options

Aspiring entrepreneurs often look to their existing assets for startup capital, and a 401(k) account can be a source of funds. Accessing these retirement savings to launch a new venture is possible through several financial pathways. Each method is governed by a distinct set of rules, carries different requirements, and results in different tax implications, impacting the capital available and your compliance obligations.

Direct Early Withdrawal and Its Tax Consequences

The most straightforward method for accessing 401(k) funds is a direct early withdrawal, also known as a non-qualified distribution. This approach has financial drawbacks in the form of taxes and penalties for individuals under age 59 ½, as the withdrawn amount is treated as taxable income.

When you request a distribution, your 401(k) plan administrator must withhold a mandatory 20% for income taxes. If you are under age 59 ½, the IRS also imposes a 10% early withdrawal penalty on the gross amount. This penalty is separate from the income tax owed and is reported on IRS Form 5329.

The combined effect decreases the capital you receive. For example, on a $50,000 withdrawal, the 20% withholding ($10,000) and 10% penalty ($5,000) reduce your available funds to $35,000. The entire $50,000 is also added to your ordinary income for the year, so your total tax liability may be higher than the 20% withheld, requiring you to pay more when you file your annual tax return.

Utilizing a 401(k) Loan

An alternative is taking a loan from your 401(k) account, provided your plan allows it. This method is not a taxable event and does not trigger immediate income taxes or early withdrawal penalties. The structure of a 401(k) loan is regulated by the IRS, which sets limits on borrowing and repayment.

The IRS permits participants to borrow the lesser of $50,000 or 50% of their vested account balance. For instance, if your vested balance is $80,000, the maximum you could borrow is $40,000. If your vested balance were $120,000, your loan would be capped at the $50,000 maximum.

The loan must be repaid within five years, with payments made at least quarterly. Payments are often facilitated through automatic payroll deductions, and the interest you pay is credited back to your own 401(k) account. A risk associated with a 401(k) loan is the consequence of default if you leave your job.

If you leave your employer with an outstanding loan, you have until the due date of your federal income tax return for that year to repay the balance. Failure to repay the loan within this timeframe causes the unpaid balance to be treated as a taxable distribution. This makes it subject to ordinary income tax and the 10% early withdrawal penalty if you are under age 59 ½.

Understanding the ROBS Plan

A more complex method for funding a business is the Rollover for Business Start-ups (ROBS) arrangement. This is a series of transactions that allows you to invest retirement funds into your new company without triggering taxes or penalties. The structure is permitted under the Employee Retirement Income Security Act of 1974 (ERISA) and requires adherence to IRS rules.

The process begins with creating a new C-Corporation, as this is the only business structure that can issue the required stock. An LLC or S-Corporation cannot be used. Once the C-Corporation is established, it must sponsor its own 401(k) plan.

You can then direct a non-taxable rollover of funds from your existing 401(k) into this new plan. The new 401(k) plan then purchases stock in the C-Corporation that sponsors it. This is known as a Qualified Employer Securities (QES) transaction.

The cash from the stock purchase is deposited into the C-Corporation’s bank account, providing startup capital. To maintain compliance, you must be a bona fide employee of the business and receive a salary. The IRS scrutinizes ROBS arrangements to ensure they are not set up solely to benefit the owner, and correct plan administration is required, including annual filings like Form 5500. The complexity often necessitates using a specialized ROBS provider.

Information and Documentation for Funding

To pursue a direct withdrawal or a 401(k) loan, you will need to provide your plan administrator with basic personal and account information. This includes your plan account number, identification details, and the specific dollar amount you wish to access. The administrator will provide the necessary distribution or loan application forms.

A ROBS plan requires more extensive information. You will need a proposed business name for the C-Corporation and the information required to obtain an Employer Identification Number (EIN) from the IRS using Form SS-4. This includes the name and Social Security Number of the corporation’s responsible party. You will also need the details to open a corporate bank account and the rollover paperwork from your current 401(k) provider.

Executing the Funding Process

To execute a direct withdrawal, you will submit the completed distribution request form to your 401(k) plan administrator. Upon processing, the administrator will disburse the funds to you via check or direct deposit after the mandatory tax withholding.

For a 401(k) loan, you will submit the completed loan application to your plan administrator. After approval, they will disburse the loan amount to you without any tax withholding. You should expect to receive a loan amortization schedule and details on when your repayments will commence.

Executing a ROBS plan involves a multi-step sequence. First, formally establish the C-Corporation by filing articles of incorporation with the state. Next, submit Form SS-4 to the IRS to obtain the corporation’s EIN. With the EIN secured, you can open the corporate bank account and then execute the rollover to transfer funds and purchase company stock.