Small business is an engine that powers the U.S. economy. According to the Bureau of Labor Statistics, business owners established 257,000 new businesses in the United States in the second quarter of 2019. Despite growth, many small business owners struggle to find capital to start or grow their businesses. In fact, the Federal Reserve found that one in three small business owners (31%) expressed that credit availability was a challenge for them last year.
With tight credit markets, many business owners turn to personal funds to get their businesses off the ground. Using personal funds to grow your business gives you more control over your finances and allows you to keep earnings in the business instead of sending money out the door to pay debts. For many Americans, money earmarked for retirement could be used to fund their entrepreneurial dream. But using retirement funds to grow a business is risky.
What to consider before using your retirement savings to fund your business
Using retirement savings to fund your venture can be risky. A business failure may limit your ability to retire on time. Plus, business owners may face unexpected taxes and penalties when using retirement funds. If you have a financial planner, consider discussing these factors before you tap into your retirement savings for your business. If you’re saving in an online brokerage account instead, check your account features. Some of the best online brokers offer access to a live financial professional for exactly these types of questions.
Amount of funding needed. Do you have enough retirement funds to get your business going? Will you use all the money in your accounts, or just a portion of it? Estimate the startup costs of your business to see how much funding you really need.
You’ll also need to plan for one-time costs such as buying equipment, designing a logo, licensing fees and similar expenses. In addition to startup costs, you’ll likely have monthly expenses such as payroll, rent and utilities that you won’t be able to cover until you’re profitable. The Small Business Administration recommends adding one full year of monthly expenses to your startup cost calculation. This calculator from the SBA can help you estimate your initial funding needs.
Taxes. When you use retirement funds to start a business, you generally have to pay taxes when you withdraw money from the account. If you take a $100,000 distribution from a 401(k), you’ll have to pay taxes on $100,000 plus your other earnings that year.
The exception to paying taxes is if you have a Roth account. A Roth IRA or a Roth 401(k) is a retirement savings account where qualified distributions are tax-free. You can withdraw the amount you contributed to a Roth account tax- and penalty-free anytime.
Penalties. If you’re under age 59 and a half, your distributions may be subject to an early withdrawal penalty. You’ll generally have to pay a 10% penalty on the amount you withdraw. This penalty is on top of the income tax you may need to pay. This is a hefty fine to pay, and may make using retirement funds unappealing.
Your age. The closer you are to retirement, the riskier it is to pull money out of your retirement accounts. If your business fails, you may have to start saving for retirement from scratch. When you’re older, you’ll have less time to build up your nest egg.
That said, being closer to a traditional retirement can be an advantage. If you’re over age 59 and a half, you will not pay an early withdrawal penalty when you use money from a 401(k), traditional IRA or other pre-tax retirement plans.
Amount of money in retirement accounts. According to TD Ameritrade’s 2020 Road to Retirement Survey, 54% of Americans age 40 or more who have a retirement account have at least $100,000 saved for retirement. One in ten had over a million dollars invested for retirement. If you have a lot of money in retirement accounts, it could make sense to use some of your retirement funds to start your business.
If you have at least $50,000 in a 401(k) retirement account, you could qualify for a Rollover as Business Startup (ROBS) arrangement. Under this arrangement, business owners can avoid paying taxes on their distributions when they use the funds to buy stock in their own startup. The ROBS arrangement is popular with franchise owners. However, the IRS warns that ROBS businesses experienced high rates of bankruptcy.
5 alternative strategies to fund your business
Borrow against home equity. If you have substantial equity in your home, you may be able to borrow against the value of your home to start your business. One way to tap into your home equity is through a home equity line of credit (HELOC). A HELOC is a revolving form of credit. That means you can borrow up to a certain limit, then pay down the line and borrow again. HELOCs currently have interest rates ranging from 3.5% to 8.63%. Around 7% of small business owners applied for a HELOC, according to the Federal Reserve’s 2019 Small Business Credit Survey.
Self-fund. Funding your business through savings gives you complete control over the business without putting your house or your retirement at risk. Bootstrapping the business is a common form of funding for small businesses. Nearly one in five (18%) of all small business owners used personal funds to keep their businesses afloat. Once your business is profitable, you can use earnings from the business to fund operations and bring in a profit.
SBA loans. Small Business Administration (SBA) loans are a form of credit specifically designed to help small business owners who may struggle to find traditional bank loans. The loans are issued by local banks, but are partially guaranteed by the SBA. Because the SBA guarantees the loans, interest rates generally range from 2.25% to 4.25% for loans with terms of less than seven years, or 2.75% to 4.75% for loans with terms of seven years or more. You can find local SBA lenders through the SBA’s Lender Match online referral tool.
Small business grants. If your business relates to scientific research or exporting, it may qualify for a small business grant. Additionally, some non-profits or local governments may issue grants to small businesses that offer development opportunities. You can work with local business organizations and business mentors to learn more about these options.
Borrow from friends or family members. Turning to friends and family members for a loan can be a useful option to get your business off the ground. Those closest to you may offer repayment flexibility and rates you won’t find from a bank. Of course, loans from friends and family carry a different risk. If you fail to repay these loans, you may damage your relationship and put a loved one in a precarious financial situation.