Many of the 6 million newly formed businesses each year rely heavily on startup capital from friends, family and in some cases accredited investors. Founders typically put in some of their own money and may withdraw from their retirement to do so. Should you consider using your retirement to start a business?
How can I use my retirement assets to start a business?
Any of your retirement assets can technically be used to start a business. However, most retirement accounts put restrictions on when the account holder can begin withdrawing funds without incurring penalties and tax liabilities. These rules are in place in part to encourage people to save money for retirement. However, that doesn’t necessarily mean that there aren’t reasons in which you may consider allocating a portion of your retirement account towards starting a business. There are even certain ways to structure the withdrawal to ensure that you aren’t subject to early withdrawal penalties or taxes on any pre-tax contributions or gains.
How much should you consider withdrawing?
This largely depends on the size of your retirement portfolio, asset allocation, your age, projected retirement expenses and many other factors. As most seasoned investors know, the common investment practice to follow is to allocate 120 minus your age in stocks and then the balance should be invested in bonds. For instance, if you are 50 years old, the textbook practice is to invest 70% of your retirement funds in stocks and 30% in bonds. If you are married, then your age would be the average of both spouses. However, that school of thought has changed with life expectancy rates rising and equity performance being less risky than previously thought. Having said that, it may not necessarily be a very risky proposition to invest 5-15% of your retirement portfolio in starting a new business venture. We would point out that this asset allocation doesn’t include the emergency cash you should always have on hand.
What are the best types of businesses to start with retirement funds?
You’ll want to reduce the risk as much as possible and only invest in established and proven business models with positive cash flow. For instance, investing in a franchised business in which the franchiser provides resources and administrative support would be ideal. Stay away from businesses that are high-risk and capital intensive. The margin of error for the amount of capital necessary to reach profitability should also be fairly low.
Is there a way to withdraw funds tax-free to fund your business?
Yes, there are ways to do it through investment vehicles such as a self-directed IRA. You can transfer money from retirement accounts to a new business tax-free because you are essentially setting up a new corporation and then purchasing stock as an investment in that new corporation via your new 401(k) plan. The Employment Retirement Income Security Act of 1974 (ERISA) made this arrangement possible and strict guidelines must be met to remain in compliance with the IRS.
Do I have to withdraw everything or can I do a partial withdrawal?
You do not have to withdraw 100% of your funds from the retirement account to use this structure. In fact, you can choose any portion of the funds to invest, and even have the flexibility of combining this option with other funding sources to make up the necessary capital to start your business.
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