When you’re looking to acquire a manufacturing business, securing the financing can be one of the most challenging aspects of the process. Lenders and investors will want to see a certain amount of personal investment on your part, so you need to have those funds available.
At the same time, maybe you simply don’t want to take on debt or have someone else involved in the running of your company. That’s why you might be considering using your 401(k) to finance your business. There are three ways to do this, according to Fundera:
- Take a distribution in cash from your 401(k).
- Finance your business with a 401(k) business loan.
- Use a ROBS — or Rollovers as Business Start-Ups — arrangement.
Let’s take a closer look at each option.
Taking a Cash Distribution From Your 401(k)
One way to get the funds you need is to make a cash withdrawal from your 401(k). However, keep in mind that you’ll have to comply with the terms and conditions of the specific plan.
Moreover, if you’re under the age of 59.5, you have to pay an additional tax of 10 percent on the distribution, unless your circumstances meet certain requirements, which you can read at IRS.gov.
Taking Out a 401(k) Loan
Technically, a 401(k) loan isn’t a loan in the true sense of the word, because it doesn’t involve another party evaluating your creditworthiness and approving the loan.
In essence, you’re accessing part of your own saved retirement funds — either $50,000 or 50 percent of your saved money, whichever is less. Even better: You can do this on a tax-free basis, so long as you repay the money on a predetermined schedule and within five years.
As Investopedia reports, a 401(k) loan can be a great way to obtain the money you need to buy a manufacturing company, especially because the interest you pay over the loan eventually goes back into your own pocket. Moreover, the process is reasonably quick, and you only pay a small origination fee.
However, it’s important to note that if you default on the loan, the IRS treats it as a withdrawal, which means you’ll have to pay an additional 10 percent tax if you’re less than 59.5 years of age.
Using a ROBS (Rollovers as Business Start-Ups)
NerdWallet explains that with a ROBS — or Rollovers as Business Start-Ups — arrangement, you create a new C corporation, for which you subsequently form a new 401(k) plan. Your existing 401(k) account is rolled over into the new one — so long as it qualifies — and those funds are then used to buy stock in the C corporation. The cash that the corporation receives from this transaction can then be used to invest in the business.
Note that while the IRS doesn’t consider a ROBS plan to be an abusive tax avoidance tactic, it does place you under significant scrutiny, since it will only benefit one individual — you. That’s why it’s advisable to apply for a favorable determination letter — or DL — from the IRS to ensure it approves of the arrangement.
Moreover, since there are considerable regulations you need to comply with, it’s wise to work with a specialized ROBS advisor or experienced attorney to ensure you remain in compliance and avoid any penalties.
Pros and Cons of 401(k) Business Financing
In general, using your 401(k) to finance the acquisition of a manufacturing business has the following advantages:
- It may be quicker than applying for a loan or financing.
- It enables you to remain in charge of the business.
- You’re not indebted to any other party.
- Your credit score isn’t at risk.
- You might get better returns from your business than you would from your 401(k).
- However, it’s also important to understand that there are significant disadvantages:
- If your business fails, you’ll lose both your assets and your retirement funds.
- You need to make provisions to repay your 401(k) or start a new one.
- You might take a financial hit due to steep taxes or legal fees.
- You could be under increased scrutiny from the IRS.
Working With an Experienced Business Broker
To avoid losing your retirement funds when using your 401(k) to acquire a manufacturing business, you should ensure that the business you buy meets your requirements and offers the potential you need to safeguard your financial future.
For this reason, it’s advisable to work with an M&A specialist – a business broker who possesses extensive experience in the manufacturing sector and can advise on the viability of the target company.