By PERRI CAPELL
Financial advisers have one word for entrepreneurs who want to fund new businesses with their retirement savings: Don't, particularly if you're under 59 1/2.
It's risky to invest in a new business, even your own, and few people ever replace the money they take out, so they have less saved for retirement. Young people who withdraw their funds and don't replace them miss out on the gains they would make over the years.
"It should be the last thing you should touch," says Kathy Boyle, president of Chapin Hill Advisers, a New York City financial-advisory firm. Still, many would-be entrepreneurs eye their retirement nest eggs as a way to fund a new business.
Plus, you'll pay a 10% penalty on what you permanently withdraw from a 401(k) account or traditional and Roth Individual Retirement Account (IRA) if you're under age 59 1/2. On top of that, you'll owe taxes on the withdrawal from the 401(k) and traditional IRA because those accounts hold pretax income.
Income taxes are assessed on only the gains you withdraw from a Roth IRA because you've already paid taxes on your initial contributions. However, if you're under 59 1/2 you can't withdraw any funds from a Roth IRA in the first five years after you start the account except for emergencies.
Ms. Boyle says only about 5% of her clients choose this avenue. Women tend to be more likely to go this route, since they don't borrow from banks and other traditional sources as much as men to start new companies, reports the Center for Women's Business Research in Washington, D.C.
Susan Bond was building a career-counseling business at night and on weekends in 2001 when she was laid off from a full-time job as head of project management for a Chicago interactive ad agency. The layoff accelerated her start-up plans, but she didn't receive the severance payment she was expecting to tide her over until her counseling revenues increased. To stay afloat, she cashed in her retirement accounts and borrowed on credit cards and from family.
"I did it the way people tell you not to," says Ms. Bond, 36. "It was a tough time for me, but it was an investment I was willing to make, and I'm happy I made it." She expects to replace her former six-figure salary with business income within the next two years and to start funding another retirement account shortly.
If you feel you have no choice but to tap retirement accounts to fund a business, be aware of the consequences, especially if you're under 59 1/2. You can lessen your pain by taking as many of the following steps suggested by financial experts as you can.
Take advantage of Internal Revenue Service rules to withdraw from a rollover IRA without penalty.
Employees who leave companies can transfer the money in their 401(k) accounts to rollover IRAs. You then can withdraw funds from such an account without being taxed or dunned the 10% withdrawal penalty as long as you replace it within 60 days, says Kay Shirley, an Atlanta financial adviser. Such a withdrawal can be done only once annually.
Taking funds from a retirement account this way makes sense "if you're in a tight fix and you know you can get it back in your rollover account within 60 days," says Ms. Boyle. She cites the example of a Connecticut search executive who left a large recruiting firm to start her own company but was barred from working for her old clients for a certain period. To tide her over until she began to receive recruiting fees, she withdrew about $50,000 of the $200,000 in her IRA and then replaced it within 60 days, says Ms. Boyle.
Don't use all your funds for the business.
Regardless of how good an idea you have for a company, roughly two-thirds of new businesses fail in the first five years. If you use only part of your retirement savings and the business doesn't work out, you still have some left to fall back on.
Carl Clayton had high hopes when he started a Mail & More franchise in Roswell, Ga., in December 2003. Two-thirds of his initial $180,000 investment to set up the franchise came from savings, and one-third came from retirement funds the former Bell South vice president had accumulated during his 30 years with the company. Mr. Clayton, 57, paid taxes and a 10% penalty on his withdrawal -- an amount equal to about 25% of his withdrawal.
Nearly a year later, the store is still in the red, and Mr. Clayton plans to liquidate or sell it in January. He advises other early retirees to first seek bank loans and then tap savings to fund new enterprises. Barring that, withdrawing from a retirement fund makes sense, he says. "However, I would recommend that no one takes out but a portion of their funds because you don't want to put yourself in financial jeopardy with a business," he says. "The business might not make it."
New entrepreneurs also should have enough funds set aside to last at least two years, says Mr. Clayton. Despite the financial hit he took on the retirement withdrawal, he notes that at least he doesn't have any debt.
Take the money out in small amounts.
Withdraw money in increments only as you need it, not all at once. This way, you'll pay taxes and penalties only on what you actually use.
Ann Van Damme and a friend started A World Class Concierge Service Inc., a Chicago-based personal-assistance company, in January after she was laid off as a sales executive for an employee-relocation company.
Ms. Van Damme is 60 and needs to be careful to make her retirement funds last. Still, she was concerned about how she would pay back a bank or other loan to fund her share of the start-up costs if the business didn't succeed. So she took her initial investment in the company -- $2,500 -- from her retirement account. She's since taken out about $27,000 more in small withdrawals to support herself as the business grows.
Although at 60, Ms. Van Damme doesn't have to pay the 10% penalty on withdrawals from IRAs, this money will be taxed. It also is a bigger chunk than the typical retiree might take out in the first year of retirement. She expects the outflow to taper off shortly as the business starts to earn income, and while advisers say IRA withdrawals are rarely replaced, she is committed to returning the funds she's used.
"I view this as a short-term loan to myself," she says. "I felt it was better to borrow from myself so I wouldn't have to pay it back and pay my living expenses if this didn't work out."
Annuitize your withdrawals.
Another IRS rule might allow you to withdraw funds from your IRA to start a business without being charged the 10% penalty, says Ms. Shirley. Under the 72(t) rule, you can withdraw retirement funds from your account as long as they're paid out to you in "a series of substantially equal periodic payments" -- much like an annuity -- based on a calculation of your life expectancy.
For instance, assume you're 52 years old and you're expected to live another 24 years. You could begin withdrawing from your IRA in equal amounts over those 24 years without paying the 10% penalty. You would, of course, be taxed on the withdrawals, unless you are taking the money from a Roth IRA.
"This is designed so people can take early retirement and take income out without penalty," says Ms. Shirley. "The withdrawals are done at a rate the IRS believes wouldn't jeopardize your retirement nest egg."
Borrow from a 401(k).
Moonlighters who start businesses while still working full time can borrow from their 401(k) accounts at no penalty as long as they pay it back within five years. Although company 401(k) plans can vary, many allow you to borrow up to 50% of the principal. Even better, you'll be paying yourself back with interest, "which might be better in this market" than the returns of the funds in your account, says Ms. Boyle.
Make sure you can afford the monthly payments on your loan to yourself. For instance, if you borrow $50,000, you'll be required to repay $10,000 annually, or $830 monthly. And if you decide to quit your day job because the business is going so well, be ready to pay off the entire amount before you resign or it will be reported as income.
Time your withdrawals.
If you pay attention to when you take out funds from your traditional or Roth IRA, you can delay the tax bite. If you can defer a withdrawal until January or February of 2005, for example, you'll postpone having to pay penalties for early withdrawal or taxes until 2006.
Another strategy might be to take a 60-day withdrawal near the end of the year, then repay it by borrowing on your credit card, says Ms. Boyle. Then you can take another 60-day IRA withdrawal in January to pay off your credit-card bill.
Have a good accountant.
If you decide to use IRA or 401(k) funds to start a business, work with a financial adviser or accountant to minimize the taxes and penalties you'll have to pay. Any losses your new business incurs during its first years can be used to offset the taxes on your withdrawals, financial advisers note. Ms. Bond says the losses from her new career-counseling business cancelled out the taxes and penalties she owed on the $10,000 IRA withdrawal she used to start it.
-- Ms. Capell is a senior correspondent for StartupJournal.com. She can be reached at frances.capell@dowjones.com.
