Hit the 401k to start a business?

October 1, 2009 3:17 PM

I'm thinking about cashing out my 401k to help start a business. I know I will pay a penalty, and that what I take out will be taxable income, but I expect my business to post a loss the first year that would offset most of (if not all) of this income. Would I still have to pay taxes on all of the 401k money?

The business I am planning will take a while to get going, and I expect a significant loss the first year- probably more than I take out of the 401k.
I'm also wondering if rolling over into an IRA and then pulling the money out might mitigate some of the penalty and/or taxes.

posted by wezelboy to work & money (8 comments total)

I'm nowhere near a tax accountant, and I usually file a 1040EZ at that, so I don't know how your losses will offset your income. But, the 10% early withdrawl penalty is directly added to your tax owed, so no amount of income loss will offset it.
posted by hwyengr at 4:13 PM on October 1

You can't mitigate the penalty, which I believe is 10% That's a big hit.

You're going to need a good accountant when you have a business, so get one now. There's significant variability in competence, so look hard for an accountant who knows small businesses. Also, there will be a branch of the Small Business Administration in your area. Use them; they can be really helpful.
posted by theora55 at 4:21 PM on October 1

You definitely need to talk to a good accountant. Apart from the 10% penalty, are you sure that you'll be able to use any loss from the business to offset your personal tax liability? This may depend totally on how you structure your business, so you need extremely sound advice about that issue before you take any money out of your retirement plan it may work out to be an extremely expensive way of funding your business if you aren't aware of all the ramifications.
posted by Lolie at 4:39 PM on October 1

You need to talk to an accountant but generally, you cannot take loses from a business, either as a Schedule C sole proprietorship or as an S-corp and carry them over to your 1040. Than do not offset your 401k taxes.

If you roll over into an IRA you will pay the same taxes and penalty.
posted by JackFlash at 5:40 PM on October 1

Meaning if you roll it into an IRA and then pull the money out, it won't get you off any hooks.

Are you still employed by the company whose 401k it is? Some 401k plans have liberal borrowing privileges. (Most do not.)
posted by small_ruminant at 6:19 PM on October 1

You may want to check with your HR department first before an accountant. Some company 401k plans may not let you withdraw the money at all while you are still employed with the company unless it is a hardship withdrawal.
posted by Yorrick at 7:05 PM on October 1

I'm not employed, so I'm pretty sure I can at least get at the money.

I think getting a good accountant is the way to go...
posted by wezelboy at 7:36 AM on October 2

I'm an accountant-in-training with a special interest in taxation. (I am not your accountant, this is not professional advice, etc., etc.) I recommend that you get advice that is tailored to your situation from an accountant who specializes in tax planning for small businesses.

In general, though, I would not recommend taking an early distribution from your 401k to launch a business. I suspect it would be a very expensive option when all is said and done. As far as I can tell, a net operating loss (NOL) from your business would not 'offset' the taxes and penalties you would pay. NOLs result in deductions against taxable income of a different tax year. NOLs can be carried back 2 years, or carried forward for 20 years, until the loss is used up (here's an example).

Furthermore, you would be losing the power of compound interest on any funds you withdrew. In essence, you would be halting the tax-deferred buildup and replacing it with a taxable investment (and a risky one at that, considering the failure rate of new businesses).

As others mentioned, you would pay tax and an additional 10% penalty on any funds you withdraw from your 401k before you reach age 59 1/2. Rolling over into an IRA would make no difference; you would still pay the same tax and penalty. (There are exceptions to the early distributions tax, but I'm assuming you don't fall into any of these categories).

Some companies allow employees to borrow against their qualified 401k plans under certain conditions, such as a first-time home purchase. It's risky, though, because if you were to close out the plan before paying back the loan, or if you lose your job and default, it would be considered a distribution, and additional tax and penalties would apply.

IRS publications (PDFs) you can read for further information:

Pub 575, Pension and Annuity Income
Pub 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts
posted by velvet winter at 1:50 PM on October 2