Business Loan vs. Retirement Funds: Which Type of Funds Should You Use to Finance a Business?

Are you ready to become your own boss but unsure how to finance your new business endeavor? Starting a new business isn’t easy, but the rewards can outweigh the risks. But coming up with a profitable business idea is just the beginning. For many, the most challenging part of starting a business is finding capital.

Many options are available to those who want to begin an entrepreneurial journey. The first place you should start is with your personal savings. But when the well runs dry, what’s the next best option?

Most people go straight for business loans, while others choose to dip into their hard-earned retirement savings. Unlike business loans, retirement savings is money you already have stored away. Plus, using retirement funds to finance a business can be more tax-efficient than applying for loans.

But there are serious risks involved with using retirement funds to finance a business and many benefits that come with business loans, especially when it comes to personal liability. Before you apply for a business loan or take out a loan from your 401(k), it’s important to understand the pros and cons for each option. This deep dive into business loans and retirement funding will help you weigh the pros and cons to decide which route suits your business idea.

Types of business loans

Many people are afraid to apply for a business loan because they aren’t sure how they work or what options are available. If this sounds like you, then you are not alone. According to a recent survey of business owners, 60% of respondents stated they did not feel knowledgeable about accounting or finance. Let’s begin by going over the many types of business loan options that are available to businesses.

Term loans

A term loan is a common form of business financing where business owners receive a lump sum that they must repay with interest over a specific period. You can find many term loan options with banks and online business lenders. But term loans are best for businesses looking to expand their existing business.

SBA loans

The Small Business Administration offers guaranteed loan options through servicers such as banks and other financial lenders. The repayment periods for SBA loans vary based on how you plan to use the funding, but you can expect a range of about seven years for working capital. This type of loan is best for borrowers with solid credit who can wait longer for funding since it can take a while to get approved.

Business lines of credit

When you open a business line of credit, you have access to funding up to your credit limit. You only pay interest on the money you have drawn, making it a far more flexible option than term loan financing. Business lines of credit are good for entrepreneurs with short-term financing needs.

Equipment loans

An equipment loan might be right for you if your business idea involves using business equipment. The loan terms are usually matched with the life span of the equipment you want to buy, which also serves as collateral. Equipment loans are best suited for entrepreneurs that want to own their business equipment outright.

Invoice factoring

Invoice factoring is not a go-to funding option for companies looking to raise capital, but it plays a crucial role for many beginning entrepreneurs. If you have a lot of unpaid invoices and you need cash now, then you can sell the invoices to a factoring company which will then collect from the customer when the time comes.

Invoice financing

Similar to invoice factoring, invoice financing uses the invoices as collateral to get a cash advance instead of selling them to a factoring company. Invoice financing is a good choice for business owners that need cash flow but want to maintain control over their invoices.

Merchant cash advances

Merchant cash advances are similar to term loans since you receive a lump sum of cash that you can use to finance business costs. But instead of making a fixed monthly payment on your cash advance, you can make payments in one of two ways. Either make fixed withdrawals from a bank account or withhold a percentage of daily sales to cover your loan expenses.

Business credit cards

Business credit lines are revolving lines of credit that behave like personal credit cards. You can use a business credit card to cover business costs as long as you make the minimum monthly payments. This financing option is best for entrepreneurs with ongoing expenses like utilities, office supplies, and travel.

Microloans

A microloan is a miniature version of a traditional business loan. It is a small loan of $50,000 or less that is typically offered through nonprofits and mission-based lending institutions. These loans are geared toward startups, newer businesses, and businesses that operate in low-income or disadvantaged communities. These loans are best for startups seeking a small amount of financing to get their business off the ground.

Ways to finance a business with retirement funds

In addition to traditional business loan options, there are also ways to finance a business using your retirement funds. Dipping into retirement funds to start a business isn’t an option for everyone, but there are ways to finance a startup with your retirement successfully. While there are numerous business financing options, there are only three ways to use retirement funds to start a new business:

Taxable distribution

If you have an IRA, you can take out a taxable distribution from your retirement anytime. But if you are younger than 59.5, you will have to pay taxes and an early distribution penalty. However, you can withdraw your contributions without consequence if you have a Roth IRA.

401(k) loan

Some 401(k) plans allow plan owners to borrow up to 50% of their account value, or $50,000, whichever is less. Borrowers typically have five years to repay this type of loan, but you must make payments at regular quarterly intervals and with interest. The upside is that these funds come tax and penalty-free, and you don’t have to pay a higher interest rate to an outside lender.

ROBS

Rollovers as Business Start-Ups project, or ROBS, allows you to use an unlimited amount of retirement funds tax and penalty-free. But your business must meet some requisites before you are eligible for this program. You must establish a C-corp with a 401(k) retirement plan and roll the funds from your personal 401(k) into the corporation’s retirement plan. Then, the company’s stock can be purchased at fair market value, generating the capital you need to launch your startup.

Dangers of borrowing from your retirement to fund a business

Just because you can use your retirement funds to finance your new business doesn’t mean you should. There are several dangers that come with dipping into your retirement savings to fund your startup.

For one, if you leave your job before your loan is paid, you will still be required to make payments until the loan is paid in full. Plus, if you’re younger than 59.5, then the unpaid balance of your loan will be considered an early withdrawal, subject to penalty fees and even income taxes.

Additionally, if your business is unsuccessful, you are still responsible for paying back your borrowed money. If you withdraw from a Roth, you could run out of retirement funds if you burn through your contributions, limiting your retirement possibilities.

Considering the pros and cons of using your retirement savings to finance your business is essential. Before you withdraw any money, find out what your retirement funds will look like if your company goes belly up. Decide if the loan is worth missing out on tax-advantaged growth of your 401(k), and make sure you can afford the loan payments.

For many, the best option is to use a low-interest business loan or line of credit to help get their business off the ground. But if something happens to you, your spouse, children, or business partners could be responsible for making payments on the 401(k) loan. In either case, it’s crucial to have a backup plan such as a life insurance policy.

Term life insurance policies offer cash-out options, which could be helpful in the event your startup goes under. Calculating life insurance accurately can ease the financial burden on your loved ones if the worst-case scenario happens. Plus, it’s crucial to have a life insurance plan in place anyway, whether or not you intend to start a new business.

Why a business loan is the best choice for business financing

As you can see, using retirement funds to start a new business is possible for some who aren’t interested in taking out a business loan. But significant risks and personal liabilities can make or break your financial stability. For most entrepreneurs, the best choice for business financing is to start by looking for business loan options to meet daily business needs and launch your company.

Here are the top reasons why a business loan is one of the best choices for business financing:

You can borrow a large sum of money to cover significant business expenses.
Business loans offer easy access to funding.
Interest paid on business loans is tax deductible.
If your business is unsuccessful, you may not have to repay the loan.
Your business credit will get a boost.

Other ways to finance a business

Besides retirement savings and business loans, there are other ways to finance your business dreams. For most people, the first step should be to use their savings. If you haven’t started savings, look for a personal savings account that comes with features such as a high interest rate, an easy-to-use app, and excellent customer support.

The next step is to cash out any investments not tied into your 401(k). Many entrepreneurs have started investing in crypto due to its high liquidity and wide selection of coin options. Although the market is volatile, investing in crypto can be a lucrative endeavor for entrepreneurs looking to raise capital for their latest startups.

Once you’ve maxed out your personal savings and investments, it’s time to look for potential investors to help you finance your business. Venture capital investors offer startups seed money for their ideas in exchange for a share in the company and sometimes an active role in your organization. While sharing ownership is not always appealing for entrepreneurs, having an experienced business professional on your team can be beneficial.

If venture capital isn’t your thing, there are plenty of financing options to help you start your own business. For example, crowdfunding is a very low-risk way for up-and-coming business owners to finance their dreams. Crowdfunding usually involves submitting your business idea to a platform where tens to hundreds to thousands of investors and lay people can contribute to your business fund.

If you still need financing but don’t want to apply for a business loan yet, then your final option is to take out a personal loan to fund your startup. Many personal loan options exist, including banks, large financial institutions, and even online lenders.

At the end of the day, it doesn’t matter where your funding comes from so long as it is legal and meets the needs of your unique business plan.

Final thoughts

Aside from business loans, several other options are available for business financing. Check out alternatives such as crowdfunding, government funding programs, investors, and personal loan options before using your retirement savings to fund your new business idea.

Be sure that you have gone through all your other options before you dip into your retirement savings to fund your next business idea. While it can be tempting to use the money you have saved throughout your lifetime, there is always the chance that the business fails and you’re left with nothing to fall back on. The best choice for most entrepreneurs is to choose a business loan option that meets their startup needs and nothing more.