In the early stages of starting a business most entrepreneurs, at least those who are doing it for the first time, are looking for any and all sources to fund their new start-up. One source of funding (i.e. venture or seed capital) that a lot of entrepreneurs have access to is their 401(k) retirement account from a previous employer.
For example, there are a lot of start-ups created by entrepreneurs who used to work at Epic, the massive health IT company based in Verona, Wisconsin. People work there for five years or so, making decent money and saving up in their 401(k). When some leave to start a business they have a 401(k) account which can look really appealing as a source of funding for their new venture. But “Should I use my 401(k) to fund my start-up?” is the question anyone considering this source of funding should be asking first. (For more, see: Business Start-Up Costs: It's in the Details.)
What Is a 401(k)?
In order to answer the question about using your 401(k) to fund a start-up you should first know what it is. According to the IRS: “A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts.” In other words, it is a retirement plan sponsored by your employer that allows you to save money out of your paycheck for your retirement.
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.
Distribution Rules for a 401(k)
How do you take money out of your 401(k) and what happens when you do? According to the IRS, generally, distributions of elective deferrals cannot be made until one of the following occurs:
- You die, become disabled or otherwise have a severance from employment.
- The plan terminates and no successor defined contribution plan is established or maintained by the employer.
- You reach age 59½ or incur a financial hardship.
How will you be taxed on your distribution? 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. (For more, see: How to Fund a Start-Up with 401(k) Assets.)
The Cost of Withdrawing Money from Your 401(k)
Here is a real world example 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 in to 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.
Should You Use Your 401(k) to Fund a Start-Up?
So should you use your 401(k) to fund your start-up? It depends. 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. There will be taxes and you will have less than you thought you did for your start-up. Also, don’t forget that this money will no longer be invested for retirement many years in the future.
If you are aware of the consequences and okay with the fact that you will lose a big chunk to taxes, then using your 401(k) to fund your start-up may be a great way to take your business to the next level or at least keep it going until you can raise more venture or seed capital. (For more from this author, see: 3 Personal Finance Tips for Entrepreneurs.)