Can I Invest a 401(k) in a Start Up Business?

by Leslie McClintock

Generally, you can tap your 401k plan to invest in a start-up business, but only if your plan allows it and then only under certain conditions. You may choose to pull your money out of a 401k plan altogether, roll the 401k over to an IRA and then establish a self-directed IRA, or take a loan out of your 401k plan and pay it back gradually over up to five years. Each approach has advantages and disadvantages.

Cash Out Your 401k

You can only cash out your 401k to invest in a start-up business if your plan rules allow it. It is generally no problem if you have left the company already. If you are still working for the company, your company must allow for in service withdrawals. If you do take a withdrawal, and you are younger than age 59 1/2, or age 55 if you have retired, you will pay a 10 percent penalty, plus income taxes on the entire amount you take out. Your plan sponsor will withhold 20 percent of the pre-tax balance to pay income taxes. However, once this is done, you have no further obligations to the 401k plan.

Execute an IRA Rollover

You can roll your 401k over to an individual retirement arrangement, or IRA. These plans allow you to invest your IRA assets in a closely held business, in certain circumstances. You must observe prohibited transaction rules, and you cannot pledge the IRA as security, borrow from it or lend to family members. You can, however, establish a business checking account, form a corporation or limited liability company and invest your IRA in your own start-up company. Rules are complex; be sure to consult someone with experience in self-directed IRAs before making any commitments or moving money out of the 401k.

Borrow from Your 401k

Some 401k plans allow plan participants to borrow against their 401k balance. If your plan allows it, you can borrow a portion of your 401k balance and use the proceeds as start-up capital for your business. Use caution, though: You must pay yourself interest on the loan, and you must pay yourself back with after-tax dollars. You must also repay the loan within five years or the entire amount borrowed will be deemed a distribution that's subject to income taxes and penalties. If you leave the company, voluntarily or involuntarily, you may have to repay the loan immediately or risk having the loan balance deemed a distribution.

Considerations

Because 401ks are qualified pension plans, they receive significant protection against creditors, and are difficult to collect against if you lose a lawsuit. Even the IRS has trouble collecting on 401k assets. IRA accounts, on the other hand, receive creditor protection up to $1 million under federal law.