401(k) Rollover vs. Distribution – Which Is Best?

Rollover for asset-based business

If you are looking at starting a new business or franchise, buying an existing business or franchise or even considering business recapitalization – and need funding to do so – you need to know the difference between a 401(k) Rollover and a Distribution.

Spoiler alert: knowing the difference will help you make the most informed funding decision AND a 401(k) Rollover is not always the best move financially. What? You mean Tenet Financial is in the business of selling 401(k) Rollover Plans and they don’t always push Rollovers? That’s right, we don’t. Keeping reading to learn more.

There are two primary types of businesses operating today:

  1. Service-based businesses – such as Mr. Electric, Mr. Rooter, Pillar To Post, Mosquito Squad, etc. These businesses operate by providing a service to a residential or commercial customer by traveling to the customer to provide the service. Typically, service-based businesses have lower initial costs to get into the business and they are very scalable.
  2. Asset-based businesses – most brick and mortar stores would fall under this category, including franchises like AlphaGraphics and Wayback Burgers. These businesses have not only the real estate their business is sitting on, but also assets like furniture, fixtures and equipment. Asset-based businesses are typically higher cost investments initially.

Now that we’ve identified and explained these two business types, let’s look at costs on 401(k) Rollover vs. Distribution.

  • 401(k) Rollover Plan – initial cost of $5,000 to set up the Plan, plus $120 monthly ongoing for administration of the Plan.
  • Distribution – subject to both a penalty for early withdrawal (10% +/-) and tax (20% +/-) in the form of income tax on the amount withdrawn, due and payable the following year on April 15. *Note that age and personal income tax bracket play a role in this estimate as well and the numbers can/do change.

If you do the math, it’s easy to see how a 401(k) Rollover is very common for service-based businesses as a stand-alone funding alternative. A 401(k) Rollover has a set upfront cost and known monthly cost, is not taxable and does not incur a penalty from the IRS, and zero collateral is needed to secure the Rollover.

Consider this example: John Smith needs $75,000 to start his new service-based business. John has $20,000 liquid cash in savings he plans to withdraw and $60,000 in his IRA. If John choses a 401(k) Rollover for the remaining $55,000 he needs, his fees will be $6,440 for the initial set up and one-year of Plan administration. That’s it. No hidden fees or surprises come April 15. No repayment schedule of the $55,000 from the 401(k) Rollover is required. Should the business close, John isn’t maintaining debt and making payments on a business that is no longer operating.

What if John chooses a Distribution for the $55,000 additional funds he needs to start his business instead of a 401(k) Rollover? John would owe a 10 percent penalty on the $55,000 Distribution ($5,500) and approximately another 20 percent in taxable income ($11,000) at tax time the following year. That’s $16,500 in total, a difference of almost $10,000 in year one as compared to a 401(k) Rollover. In this example, a 401(k) Rollover IS the best move financially for John Smith.

Now, for asset-based businesses that require more initial cash injection, they’ll likely need additional capital above and beyond a 401(k) Rollover or Distribution to help start their business, such as SBA Loans. Next week’s blog will address this common funding situation, so be sure and check back to learn more.

Can’t wait for the next blog? Want to learn more about 401(k) funding, SBA Loans and other business funding options? Contact Tenet Financial Group today at 1-888-901-3335, x. 9 and we’ll be glad to answer your questions.