#AskGradMoney: Can I Use my 401(k) to Fund a Startup Company?
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Anonymous, New York:
"I'm excited to start my own business but I need funding to get it going. I would normally go to a bank to get a loan, but I have enough money already in my 401(k) from a former employer. Can I use this money to fund my startup instead?"
Congrats on the new business - it's an exciting time! That being said, it can be appealing to see that much money at your disposal as a good source of funding for a new venture, but is it really wise to do? Generally the money you contribute is on a pre-tax basis, unless you are using a Roth 401(k), in which anything you contribute is not included in your taxable income in the year you put it into your 401(k). As your money hopefully grows, it does so in a tax deferred manner and you are not taxed on any of the money in the account until you take it out at some future date - and this is the first consideration:
1) Can you afford to pay the income tax on that amount of money you are taking out?
Regardless of the reason for withdrawing money from your 401(k), you will be subject to income tax on any amount you withdraw. More importantly, if you don’t qualify for one of the IRS exceptions you may pay a 10% additional tax on your distribution -- as we discussed in previous posts related to early withdrawal from an IRA. If you take out $40,000 for example, you will have to pay income taxes on that, plus an additional $4,000 disappears and immediately goes to the IRS as a fine for taking the money out early.
2) Can you even withdraw money from your 401(k) yet?
According to the IRS, distributions to 401(k)s generally cannot be made unless one of the following things occurs:
You die, become disabled or otherwise are separated from employment
The plan is terminated and is no longer maintained by the employer
You reach age 59 1/2
- You incur a financial hardship, and this hardship has to meet very specific criteria and there is usually a limit on how much can be used.
3) There is a BIG cost to forfeiting your retirement savings
Here is a real world example from Investopedia to show the implications of using your 401(k) as seed capital for your start-up. Hopefully this should help you decide if using your 401(k) is the right choice...
Julie, a single 26 year old, has been working at PlantetHealth IT Company for the last four years. She has learned a ton about the health tech industry and through working directly with the company’s customers has noticed a particular problem that is currently not being solved. With the help of one of her coworkers they have developed a solution that they think the market is hungry for.
After speaking with their family and friends about their idea, she and her friend decide to go all in, quitting their stable jobs to start a company. They both have been able to save up some money in savings and plan on using it to get the company off the ground.
Six months into this new venture they have realized that it is going to cost more and take longer than they anticipated. So, they are now looking for other funding sources before asking their families and friends for seed capital. Julie managed to save up $35,000 in her 401(k) over the four years she was working, she rolled it to an IRA right after she quit her job. This money would be very helpful for the business so she decides to take the money out to help pay for start-up costs. This is what will happen if she withdraws the entire amount:
The $35,000 will be taxed as ordinary income for the year she withdraws it. Assuming a 15% federal tax rate and single filling status, she will pay ~$4,783.75 in federal income tax, plus an assumed state income tax of ~5% equaling $1,750.
On top of this, since this distribution does not qualify for one of the IRS exceptions, she will pay an additional 10% tax on the amount withdrawn, thus paying an additional $3,500.
Julie will end up paying ~$10,033.75 in taxes to withdraw this money from her 401(k). In other words, she will lose over 28%, almost a third, of her money to taxes. Some of this tax may be offset by business expenses she is able to deduct, but it will come down to her specific financial situation for the year. For your specific situation make sure to consult with a tax professional before withdrawing the money to get a clear idea of how you will be impacted.
So back to the original question: can you use your 401(k) money to fund your startup? The answer is: it depends. Honestly, I think what is more important is that you are aware of what will happen should you decide to use your 401(k) as seed capital, plus there will be taxes and you will have less than you thought you did for your start-up, and don’t forget that this money will no longer be invested for retirement many years in the future. I would suggest seeking out venture capital money to fund your business, but if you still disagree, just understand the consequences and be prepared to lose a lot of that money to taxes.
I wish you the best of luck in your future endeavors!
For more information on financial planning, you can visit Investopedia, by CLICKING HERE.