With small-business loans and second mortgages scarce these days, some middle-age entrepreneurs are starting companies using their retirement savings, a novel financing method that they say avoids loan payments and early withdrawal penalties.
These business owners are effectively treating their start-up ventures as any other stock in their 401(k) portfolio, and in the process they are providing seed capital for their own budding enterprises. In some cases they are even paying themselves a salary as their businesses start generating cash.
It’s a risky strategy, one that has business owners essentially betting their retirement on their company. But beyond that, it is a controversial, considering that the same person is serving as financier, chief executive and salaried employee. And because it is all being fueled by pretax retirement dollars, the tax consequences are unclear.
But that has not stopped several advisory firms and hundreds of their clients from promoting it as the ultimate start-up strategy that, during a widespread market crisis, lets you invest in the one thing you have control over: yourself.
John Mickey of Chicago came upon the retirement-financing idea last spring as he sought to become an independent businessman for the first time by buying a franchise after about 20 years working for big companies. He zeroed in on Adventures in Advertising, a company in Neenah, Wis., that makes promotional items like pens, coffee mugs and golf balls imprinted with company logos.
He needed $30,000 to buy the franchise rights, but with no track record as a business owner, he knew he could not get a small-business loan from a bank. A home equity loan was also not an option, because he had not owned his home long enough to build much equity.
So his franchise consultant suggested that he look to his 401(k) retirement accounts, worth about $160,000 combined. That gave him several options. He could simply cash out some of the balance, but at age 46 he would have paid a hefty penalty tax for early withdrawal. Or he could borrow against his holdings, but that would have saddled his young company with the overhead of monthly payments.
“I didn’t want to have a loan to pay off, and I didn’t want to be taxed up the wazoo for cashing out the 401(k),” he said.
Photo by Steve Kagan.