How to Invest in a Personal Business from a 401k

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Most people are unaware that investing in a personal business is possible with funds from their 401(k). While uncommon, it can be done. There are two ways to invest in a personal business with 401(k) money. Your individual employment situation will determine which of the two you are eligible to use.If you are still employed by the company that administers your 401(k), the process is fairly straightforward. If you are no longer employed by the company, the process is a little more involved and there are additional legal and tax ramifications you must consider. Both methods are explained below.

Things You'll Need

  • 401(k)
  • Self-Directed IRA with check writing privileges (if you are no longer employed by your 401(k) administrator)

IF YOU ARE STILL EMPLOYED BY THE COMPANY ADMINISTERING YOUR 401(k)

  • Find out if your 401(k) has a loan provision. Almost every 401(k) plan allows loans. Most plans allow participants to borrow up to 50 percent of the vested amount in their 401(k) up to a maximum of $50,000.

  • Determine the interest rate and repayment period. Your HR department will be able to tell you the current interest rate for 401(k) loans. You are allowed up to 5 years to repay the loan, though the repayment period can be shorter if you choose. Loan payments are automatically deducted from your paycheck.

  • Apply for the loan. Depending on company policy, this can be done as easily as making a phone call to HR. Most companies require a short application form, though. Credit is not an issue as the money you are being loaned is already yours.

  • Invest in the personal business of your choice. There are really no legal restrictions as to what you may use the money for, although some employers do choose to restrict 401(k) loans to certain specific purposes. Once again, check with HR.

  • Repay the loan! This is a very important step because it can cause you major tax problems if you do not. If you leave your employer before you've paid back the loan, you may be forced to pay the remaining balance immediately. If you do not, the remaining balance will be considered a premature distribution and will be subject not only to income tax but to a 10 percent penalty.

IF YOU ARE NO LONGER EMPLOYED BY THE COMPANY ADMINISTERING YOUR 401(k)

  • Open a Self-Directed IRA with check writing privileges. This is a specific type of IRA that allows you to invest in a multitude of opportunities including private businesses, real estate, discount paper, or any other legitimate investment. The only restrictions are Collectibles and Life Insurance. Investments made from a Self-Directed IRA are granted the same tax-deferred status as any typical IRA.

  • There are a multitude of Self-Directed IRA administrators available online. Type “Self-Directed IRA” into your preferred search engine and you will find dozens to choose from. Choose the plan administrator with the flexibility and fee structure most appropriate for your intended investment.

  • Roll your 401(k) over. Notify the company administering your Self-Directed IRA that you need to complete a 401(k) rollover and they will provide you the appropriate forms. Once you submit the forms, the balance of your 401(k) will transfer to your Self-Directed IRA, usually within 3-4 weeks.

  • Invest in the personal business of your choice. However, if you are investing in your own business, there are restrictions you must keep in mind in order to avoid triggering a premature distribution.You are allowed to own or control no more than 49% of the business. You, and members of your immediate family, fall into the Disqualified Persons category as far as the IRS is concerned. In other words, if you or members of your immediate family own more than 49% of the company, the IRS believes you are taking a premature distribution and will tax and penalize you accordingly. For IRS purposes, Disqualified Persons include you, your children, grandchildren, spouse, and parents. Siblings, aunts, uncles, cousins, and step relations are NOT considered Disqualified Persons.

  • Determine if you qualify for a Class Exemption. There may be a way around the restrictions outlined in Step 4. The Department of Labor has allowed hundreds of exemptions. To see if you qualify for an exemption, visit their website at the link listed below.

Tips & Warnings

  • Always repay any 401(k) loans to avoid taxes and penalties.
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