Many entrepreneurs use their retirement money as capital to start a business. However, using retirement money to start a business can present many risks if you aren’t careful. To help new small business owners, we gathered insights from the pros on the most common mistakes to avoid when using retirement savings to fund a startup.
Here are the top 20 retirement money pitfalls when starting a business:
1. Not Looking for More Tax-efficient Options
The biggest mistake people make when using retirement funds to buy a business they will be personally involved in is not knowing there are other more tax-efficient options than taking a distribution, which could be subject to tax and a 10% penalty if under the age of 59.5. An option is having the new business establish a 401(k) plan with a loan option, and then using the ability to borrow up to $50,000 to purchase the business. The interest on the loan is paid back to the plan and not subject to tax or penalty.
2. Not Consulting a Tax Professional
Entrepreneurs should not simply drain their retirement accounts to start a business without first consulting with a tax professional. For example, you need $15,000 to start a business. You have $10,000 in a Roth IRA ($5,000 from contributions and $5,000 in earnings) and $20,000 in a 401(k). If you simply withdraw $15,000 from the 401(k), you will likely be liable for a 10% early withdrawal penalty plus taxes, and it’s such a huge mistake. However, if you withdraw $5,000 from your Roth IRA (only up to the amount of your contributions) and take a $10,000 loan against your 401(k), you may avoid paying penalties or taxes. This shows how essential it is for entrepreneurs to invest in proper tax planning before using retirement accounts to fund a new business endeavor.
3. Trying to Use ROBS Without a ROBS Provider
As an alternative to a business loan, a Rollover for Business Startups (ROBS) financing allows you to use $50,000 or more from your 401(k) or IRA to start, acquire, or grow a business. There are eligibility requirements that must be met along with filings and monitoring. There are pension consulting firms that can help (known as ROBS providers), but there are initial and ongoing fees to handle the paperwork. Trying to accomplish this without the benefit of a ROBS provider is a common mistake you should avoid. Business owners who try to set this up on their own, without the benefit of a ROBS provider, will likely encounter a total disaster.
4. Risking Your Retirement Money for an Uncertain Business
Utilizing retirement funds to start a business, especially one that is bound to fail, is simply a terrible idea. No one thinks that their business is going to fail, but the vast majority do so. There is a retirement income crisis in the United States and it continues to worsen. People who get to retirement age and have not saved enough money for retirement are left with two options: continue to work or accept a lower lifestyle in retirement. And, oftentimes, working longer is not an option because of health reasons—either the retiree’s own health or the necessity to care for a loved one.
5. Not Considering the Opportunity Cost
Withdrawing money from a retirement account can be an extremely expensive way to source money to start a business. For instance, since Traditional IRA investments are tax deferred, withdrawals would be taxed as income. In order to pay the tax, the entrepreneur wouldn’t be able to fund the business with the entire amount taken out.
Moreover, had the money been left in the IRA without tax reductions to drag down returns, gains on the full amount could have continued being reinvested tax-free. Withdrawing the money would give up those potential extra gains, which would be the opportunity cost of using those funds. Plus, entrepreneurs under age 59.5 might have to pay a 10% early withdrawal penalty in addition to paying income tax on the full amount they take out. In this low interest environment, it may be cheaper to borrow money from outside sources than to withdraw it from a Traditional IRA.
6. Failing to Understand the Risks Involved
The common mistake when trying to use retirement funds to start a business is that you are taking secured funds and now speculating with it without understanding the risks involved. Starting a bad business is a slow drain on finances; the problem is that the longer the business exists poorly, the more skin someone usually has in the game, which makes it hard to cut loose—perpetuating the downward spiral.
And when it comes to retirement savings in the golden years, this is no game to be playing. There should always be a sacred portion of your portfolio that is never touched outside of retirement. The guiding rule should always be to not lose money. Arithmetically, when you lose 50% of your principal on an investment loss, you need to recoup this money by growing the principal by 100%, which is very difficult. So not losing money should be the top priority, especially when it comes to retirement. It’s up to the individual to decide how risky using retirement funds would be in a new business venture, which also depends on the certainty of the endeavor.
7. Not Weighing All Available Financing Options
Entrepreneurs should carefully weigh all other options before deciding to cash in, or borrow from, their 401(k) to launch a business. While it can be an attractive option for those who are strapped for cash, there are less risky, alternate routes entrepreneurs can take to fund their business, like applying for a small business loan. Additionally, entrepreneurs thinking about using a Rollover for Business Startups (ROBS) option to roll over retirement funds into a new business should know the process is complex, costly, and has ongoing reporting requirements.
8. Starting a Company Around a Hobby
A very real mistake that is common with new investors using their 401(k) to start a business is choosing to start a company based on a part-time hobby. While capitalizing on what you enjoy doing for financial gain may sound like a smart move, it is essential to remember that this company will require full-time attention, with operational chores and costs that may be unpredictable upon initial investment. By considering opening a business based on one’s passions rather than a hobby, these chores and costs will feel more worthwhile and will intrinsically motivate the owner to push for the success of the business.
9. Not Considering a Self-directed IRA
People cash out their old 401(k) accounts to use that money to start a business. Unless the person is over 59.5 years old, that mistake will trigger a 10% tax penalty on top of owing income taxes on the distribution. Someone cashing out $100,000 would end up with a net $70,000 after the 10% penalty and 20% mandatory IRS withholding. A possible solution to this is to look at rolling over the money into a Self-Directed IRA, and then taking distributions from that to start the business. Each situation is unique to every individual. It’s best to consult with a trusted CPA who can explain the tax implications more clearly.
10. Failing to Budget for Setup Fees
Entrepreneurs who decide to use their retirement money to start a business through a Rollover for Business Startups (ROBS) should understand that there may be costly fees involved with setting up the account. Not knowing how much you should prepare to get professional help for a ROBS transaction may delay the process. It’s best to shop around for ROBS providers and decide which one is best for your planned timeline and budget.
11. Not Forming a C Corporation
When starting or buying a business, it’s recommended that the business owner form a C corporation along with a new 401(k) plan, and roll the retirement funds from his old plan into the new plan. The new 401(k) funds can be used to purchase stock in the business, allowing the business owner to use the funds in the business.
12. Tying Up a Large Portion of Your Retirement Funds
The most apparent risk when investing your 401(k) into starting a new business is if the business fails, you lose some, if not all, of your retirement. To mitigate the possibility of losing financial stability in the future for a new business venture, consider only investing a portion of your retirement money. This will diversify your risk while still allowing you to start your new company.
13. Not Studying ROBS Requirements
If you are considering tapping into your retirement nest egg to start a business, one option is the Rollover for Business Startups (ROBS). However, not knowing the requirements for ROBS might delay your transaction or bring frustrations. ROBS comes with several caveats. For example, you need to rollover at least $50,000 from your retirement funds in order to qualify. In addition, you also must structure your businesses as a C corporation (an LLC or sole proprietorship won’t work). There are several other legal pitfalls to avoid, so it’s best to educate yourself about all the nuances that go with ROBS before deciding whether or not to use the arrangement.
14. Taking a Loan to Fund Your Startup
Another mistake new business owners make is taking out an additional loan to fund their startup on top of the retirement money that they withdrew. An additional loan can be an added burden to your business, so you should try to make ends meet using the retirement money that you withdrew and use it wisely to make your business thrive.
15. Not Clearly Defining Your Goals
Having a clearly defined goal for your money gives you the ability to build steps and actions to take to obtain those goals. The funds that you have saved for retirement were a defined goal. If you take those funds out of the retirement plan to fund a business, it’s easy to lose sight of what those funds were drawn out for. So if you don’t have a clear goal for the funds with action plans to put those funds into use, you could end up a time later looking back and wondering where those funds went and what they were used for.
If there are no defined, clear goals for those funds, you risk piddling the money away without any significant improvement to your business and having that much less in your retirement plan. Ultimately, a business that is thriving is an excellent retirement plan, but if you draw on your retirement plan to fund a business that does not become profitable, you could be faced with a failed business and a depleted retirement account.
16. Buying a Business That Doesn’t Guarantee Income
The biggest mistake when using retirement money to purchase a business is buying into one which doesn’t guarantee your income. It’s best to seek advice from a business consultant to help you choose and buy into an industry that provides recurring revenue from the start. There are not many businesses that offer this kind of certainty, so be careful when making decisions.
17. Using All Your Retirement Savings to Start a Business
Avoid taking all of your retirement savings out for this purpose. If your idea fails, not only will you be starting from scratch, but you will also have lost time, which is a key ingredient in investing. However, for some people, taking a large percentage of their retirement savings to start a business is a motivation to instill the “this cannot fail” grit that most any business owner will attribute to their success. Out of that hunger was born a determination and a drive that propelled them to work even a little harder.
18. Borrowing Against Your Retirement Account
One common mistake when taking a loan against the funds in your retirement account is that you’ll end up not being able to pay it back. This will be a tough position to be in because in addition to struggling to make ends meet with the money coming in from your business, you will also be hit with heavy early withdrawal penalties from the IRS. Using a Rollover for Business Startups (ROBS) instead would save you from having to pay early withdrawal penalties and from a lot of sleepless nights too.
19. Not Knowing the Risk of an IRS Audit
If you decide to use a ROBS to start a business, the risk of an IRS audit could be greater. Not being aware of this risk could jeopardize your startup and your retirement. According to MarketWatch, any mistake made during the transaction could result to being disqualified from the ROBS plan, and this can cause IRS penalties and even make the transaction taxable.
20. Thinking the Process for a ROBS Transaction Is Simple
The process for a ROBS transaction is not the same as any regular business loan or withdrawal from a retirement account. In fact, the process can be so complicated that the IRS has strict compliance standards to avoid penalties. Because of this, CNN recommends working with an experienced financing firm that helps entrepreneurs set up ROBS.
Using retirement money to start a business can be very risky, but it’s not impossible. In fact, if you are prepared and know what to do, you could save a lot of money that you would otherwise be paying in interest on a business loan. If you decide to use your retirement money for your startup, make sure to avoid these common mistakes to help minimize your risk.