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How To Use 401(k) For Business Financing

There are a number of interesting ways to finance a business purchase. The most traditional method involves securing a loan from a bank or a credit union. You could also pool funds from friends and relatives or ask the seller to carry a note for a portion of the purchase price, or even all of it. But one of the secrets for small business finance may be sitting closer than you might expect - your retirement fund.

What is a 401(k) Plan?

While the pension plan has pretty much gone the way of the dodo bird, companies have found other ways to allow their employees to set aside money for their retirement. The 401(k) plan allows a salaried worker to deposit a small portion of his or her wages every pay period into a tax-exempt account. Employers offer to match these funds up to a certain percentage or dollar amount; this figure may also vary depending upon the fiscal health of the corporation - where a year with greater profits will mean a higher matching deposit. Oftentimes there are "vesting" issues, where the employer's contribution does not completely accrue to the employee until he or she has been there a predetermined number of years. No matter how these issues are structured, the money contributed by the worker is sacrosanct. Surprisingly, you can use this money for financing a business.

Penalties Versus No Penalties

Once funds are deposited into your 401(k), whether they are yours directly or else matching contributions from your employer, the I.R.S. will levy some fairly hefty taxes and penalties should you withdraw any of that money prior to retirement - which is usually set at age 65. Not only will you be required to declare the amount of withdrawal as regular income in the year it comes out of the plan, but there are penalties as well that can run well into double digits. However, the federal government does allow something called a rollover, which most people encounter when they change jobs. You are permitted to take 401(k) money from a former employer and "roll it over" into a similar plan at your new employer, or into an I.R.A. There is one additional option well worth considering for the budding entrepreneur - the Rollover As Business Startup. This is a penalty-free method of using your accumulated retirement funds for financing businesses and enjoying some financial freedom as well.

Putting Your 401(k) to Work

In small-business financing, the best choices are those that cost you the least amount of money. Using 401(k) stock to finance a business is a smart move, because the money is already yours. Rather than cashing in the shares, which invokes the penalties noted above, there are two smarter ways to get the job done. First you form a corporation that will own the small business you plan to buy, which then issues ownership shares as part of the incorporation process. At that point you direct your 401(k) to buy those shares directly. Most people believe that a 401(k) can only invest in public companies, but this is not the case. A second option requires the formation of something called an ESOP (Employee Stock Ownership Plan). The new company's shares are deposited into this plan, and the 401(k) money is used to acquire those shares. While this may seem like an unnecessary step, in some circumstances it offers tax- and estate-planning benefits that most small-business owners overlook. To achieve any of these goals, you will need the services of an attorney - notably one with tax and small-business experience - plus an accountant, a business valuation expert, and a securities firm (such as a brokerage house).

Uses for Your 401(k) Money

Here is a list of the more common expenses that can be funded by money held in a 401(k) plan. One item glaringly omitted is salary. You are not allowed to pay yourself a salary directly from those funds - it must come from revenue generated by the business, although you need not initially show a profit to earn a salary.