Can I Close My 401(k) for a Down Payment on a Business Without Penalties?

by Wilhelm Schnotz, studioD

The administrative details and rules that surround a 401k retirement plan vary among the employers who provide them, but the Internal Revenue Service requires all 401ks to adhere to general guidelines. Among these guidelines, the IRS restricts distributions before you reach qualifying age, and assesses penalties if you prematurely tap into your 401k in most situations. The IRS allows investors to access 401k funds prematurely in qualifying times of hardship, but seed money for a business isn't included in those provisions.

401k Distribution Rules

In most circumstances, your 401k's administrator won't allow you to close your 401k while you're still employed by the company that sponsors the plan. If you're no longer employed, the funds have vested and you can move them as you wish. However, you will face a 10-percent excise tax penalty if you access 401k funds to start a business, unless you're of qualifying retirement age, which is 59 1/2 years. In addition to the penalty, you'll be taxed at income tax rates on the amount of the distribution as if it were earned income.

401k Loans

If you plan to continue working and need retirement assets to fund a startup company you will operate outside of your primary job, you may qualify to receive a 401k loan. While plan administrators create rules that govern 401k loans, you may be able to borrow up to $50,000 from your account, however, you must pay it back within five years, regardless of the amount borrowed. Your plan administrator will deduct the loan payments from your paychecks, assessing interest charges that by law must be equal to the market rate. Rather than paying interest to a bank to pay back a loan, you will end up repaying yourself, by way of your 401k, with interest.

Hardship Distributions

The IRS allows you to take emergency distributions from your 401k in times of hardship. Unlike funds in individual retirement accounts (IRAs), those accessed for hardship distributions from a 401k aren't exempt from penalties. Hardship distributions, which include medical expenses, emergency home repairs or college tuition, as defined by your plan administrator, are subject to the IRS' 10 percent excise tax in addition to normal income taxes.

Rollovers from 401ks

If you no longer work for the employer who administers your 401k plan, you may consider rolling assets into a traditional or Roth IRA. While this won't allow you access to the funds without penalties -- early distribution rules are the same for all types of retirement accounts -- you'll benefit from greater control over the funds. You may roll assets from a 401k into a traditional IRA without paying any additional taxes. Because IRAs are also a pretax retirement account, you must pay income taxes when you receive qualifying distributions. If you perform a rollover into a Roth, the IRS requires you to declare all rollover assets as income and pay taxes on the amount. When you receive distributions from a Roth, you won't be faced with additional income taxes.

About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.

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