Wealth Management

How to fund your business without using 401(k) savings

There are pros and cons to every type of funding, and what’s right for your business depends on your specific goals and needs. Here’s where to start.

Tags: Business loans, Cash flow, Funds, Loans
Published: January 09, 2019

You have a great idea for a new business and now you need the money to fund it.

Whether you want to manufacture widgets, provide a professional service or something else entirely, you may be tempted to put a cash infusion into the company by pulling from your retirement accounts. This is an urge you should resist, not only because you may regret the loss of compound interest or the tax penalty you owe for draining your 401(k) early, but also because there are other funding options available.


Determine how much money you need

Because of the variables, a good first step is to decide how much financing you actually need. For instance, if you need a storefront to start, your startup costs will be higher than if you can launch with a computer in your office.

Start the process by estimating two variables:

  • Expenses are ongoing costs you’ll need for running the business (e.g., website maintenance, rent or employee salaries).
  • Capital expenditures are one-time costs that you’ll need to start (e.g., production equipment, inventory or vehicles). These costs may vary over time and some may be optional, so be realistic about what costs you actually expect.

Calculating your startup costs can help you determine both your upfront and ongoing expenses. Once you have a strong sense of the amount of capital you need to get started, begin considering different funding sources.

 

1. Retirement savings

Pros:

  •  If you’re still employed, some 401(k) plans may allow you to take out a loan using these funds.
  • All interest paid on your 401(k) loan is ultimately credited back to you, reducing the overall cost of funding.

Cons:

  • If you cash out any of your pre-tax retirement funds before you turn 59 1/2, you receive what the IRS calls a “nonperiodic lump-sum” distribution. This means you would need to pay federal and state taxes (which can be substantial), and you may have to pay an additional 10 percent tax on the distribution.1
  • There are a number of restrictions associated with taking a loan. Your loan amount will be limited to $50,000 or half of your account value (whichever is less), and you may have to re-pay the full amount of the loan if your employment were to end for any reason.
  • Even if you’re older than 59 1/2, there are risks involved in using your retirement investments. First, all distributions from your 401(k) are fully taxable at ordinary income rates.  Second, if your business venture doesn’t succeed, will you still have enough set aside to meet your living expenses when you retire?

Because of the penalties involved with cashing out a 401(k), be sure to fully evaluate any implications and explore other funding options before touching these funds. If you’re intent on using your retirement savings as seed money, consider speaking with a financial professional who can help you assess how a withdrawal may affect your retirement plans.

 

2. Friends and family

Pros:

  • Family and friends are more likely to want to see your business venture succeed, and thus may be more likely to help out with startup costs.
  • Many family loans are informal, and family members don’t expect to receive their money back or any specific type of return on investment in the near future.

Cons:

  • When money changes hands, there can be tax implications for both the lender and the borrower that are often overlooked. For example, any transferred money that does not have legal paperwork indicating it’s a loan may be considered a gift, which can be taxed.
  • Loans within close-knit groups can often carry implications far behind financial considerations. What will the effect be on your relationship if you are unable to repay the debt?

While friends and family may not be the best source for funding your startup, they can be a valuable source of help for regular operations or introducing useful contacts from their network.

 

3. Small Business Administration (SBA) loans

Pros:

  • These loans can have competitive interest rates that make them valuable for new businesses.
  • SBA loans can be given with less paperwork and at quicker speeds for businesses with less than two years in business.

Con:

  • Some loans may require you to provide historical financial documents from your business. If your business is just starting out and lacks a track record, it may be more difficult to qualify for loans.

It will be helpful to know ahead of time what you plan to use the loan for: equipment, vehicles, real estate, business acquisition, business expansion or operating expenses. And you’ll need to know how much you’ll want to borrow or open in credit — more or less than $250,000.

 

4. Investors (angel, private equity and venture capital)

Pros:

  • Outside investors are valuable because the individuals or funds tend to aid and advocate for your business in addition to providing funds.
  • Because of their financial interest in your success, many investors offer to work as advisors, either as formal or informal board members.
  • If you find interested investors, you may be able to secure funds faster than the process for a typical loan.

Cons:

  • Finding investors outside of your friends and family who are willing to put money toward your ideas can be difficult.
  • Investors may have expectations about how your business is run or want to be involved in some capacity.
  • Investors will expect a return on their initial investment.

There are a few avenues to look for potential investors. Asking a mentor how they financed their business may be helpful. Networking with other small business owners can be productive. Finally, contacting or joining small business groups — both national and local — can help you find possible investors.

 

5. Grant money

Pros:

  • There are specific grants for small businesses run by women and others for nonprofit businesses that may be easier for your new business to qualify for.
  • Searching and applying for small business grants can easily be done online.

Con:

  • Grant proposals can be painstaking and specific, so make sure to read all of the fine print and address all of the requirements when you apply.

The federal government and specific states offer funds for small business development, and some corporations or organizations do the same.2

Regardless of your potential funding, a well-thought out business plan will be invaluable. Being able to clearly articulate the opportunity that exists, the process that will allow you to develop that opportunity and the potential returns that will come as a result will increase your chances of successfully receiving your startup funds.
 

Learn more about funding options for major purchases or life events like starting a business.
 

1 401(k) Resource Guide - Plan Participants - General Distribution Rules,” IRS.gov, last updated May 2018.
2Small-Business Grants: Where to Find Free Money,” NerdWallet, January 2018.