The economic impact of the Coronavirus pandemic and resulting social distancing measures taken to protect lives and slow the spread of the disease have been catastrophic for small businesses across the country.  There is no doubt on that point.

Even as rules start to relax and economies start to open back up, it is equally certain that any economic rebound will be slow and take place in fits and starts.  For many businesses, “back to normal” may be a long way off, if ever.  Some enterprises will need to re-design and re-think their operating model to accommodate what may become a “new normal” of social distancing.

The businesses that will make it through these challenging times and have the ability to adapt to a different future will be the ones with capital.  But where can one find capital in this environment?

There are three ways you can potentially tap into tax-sheltered retirement savings without penalty.  Let’s take a look at the pros and cons of each.

Expanded 401(k) Loan

As part of the CARES Act passed in March, the participant loan provision of most qualified employer plans was increased to $100,000.  The previous limit was the lesser of $50,000 or 50% of the account value.  For a saver with $80,000 in their 401(k) or similar plan, that meant a maximum loan of $40,000.

In addition to bumping the limit, 100% of vested savings may be borrowed under these special provisions that apply to loans taken between March 27, 2020 and September 23rd, 2020.  A person with $80,000 of vested balance in their plan can borrow the full amount.  Someone with $100,000 or more in their plan can borrow up to the maximum of $100,000.

This loan provision is available from any 401(k) or similar employer retirement plan you may have that is associated with current employment – whether that is perhaps a Solo 401(k) sponsored by your own business or a plan associated with another company you work for in addition to running your own business.

Interest rates are established by the plan sponsor and are typically in the range of Prime rate plus 1 – 3 percent.

Plan loans are for a 5-year term.  For Coronavirus loans, payments are deferred until 2021 and the 5-year clock starts then as well.  Interest will accrue in 2020, but that is interest you are paying back to your own retirement plan.

If you leave or lose the job associated with the 401(k) plan you borrow from, the loan must be repaid in full by the tax filing date (including extensions) of the tax year in which termination occurs.  Some plans may have more generous terms for repaying a loan after separation from service, so check with your plan provider.  Taking a loan from a job that may not be stable is therefore not a good idea.

Pros:

• There are no taxes or penalties associated with a 401(k) loan.
• No approval required, so long as your plan offers a loan provision.
• Paying Interest to yourself.

Cons:

• Opportunity cost.  The plan could potentially make more money in investments than the interest on the loan.
• Risk of termination and need for short-term repayment of the loan.
• Loan amount is considered a distribution with taxes and any applicable early distribution penalties if not repaid according to the terms.

Coronavirus-Related Distribution

The CARES act allows eligible participants in a variety of 401(k) and IRA type retirement plans to take an early distribution of up to $100,000 during the 2020 calendar year.  The normal 10% penalty for early distribution prior to age 59 ½ is waived for these special Coronavirus-Related Distributions (CRDs)

In order to be eligible for a CRD you must have a qualifying hardship associated with the COVID-19 pandemic.  Conditions include:

• Have been diagnosed with COVID-19
• A spouse or dependent has been diagnosed with COVID-19
• Are experiencing financial difficulty as a result of being laid off, furloughed, having work hours reduced, or by being quarantined
• Are unable to work because of a loss of childcare as a result of COVID-19
• Own a business that has closed or is operating under reduced hours
• Meet other criteria as determined by the IRS

The $100,000 limit is per individual and may be taken from one or more eligible retirement plans.

Not all qualified employer plans are required to offer such hardship provisions, but the general feeling is that a majority of employers will.  Be sure to check with your plan administrator.

In addition to the waiver of early distribution penalties, there are some other features of the CRD program that make this a workable alternative to access capital without necessarily putting a big long-term dent in your retirement savings.

Distributions from a 401(k) or similar employer plan are not subject to the normal 20% tax withholding.

The taxes on the distribution may be paid over a 3-year period of 2020, 2021 & 2022.  Alternately, you can choose to pay the taxes in full in the first year.  Paying in year one would be the better option if you intend to re-contribute the funds.

During the 3-year period beginning with the date of a CRD, you can re-contribute funds back into your retirement plan and are not limited to normal contribution limit amounts.  Such re-contributions are treated like an indirect rollover, but without the 60-day limit and requirement of one such transaction per 12-month period.

Rollovers may be done in one payment or with several contribution transactions over the 3-year period.

Any rollovers that occur after payment of taxes and a tax return will require filing an amended tax return to have the taxes paid refunded.  As such, it may be best to pay taxes in year one to minimize the number of amended returns that may be required.

If you have access to a 401(k) loan from a stable job, that is likely a simpler and more direct option.  Using a CRD would be appropriate for individuals who do not have an active 401(k) from which to take a loan, or if they may already have an outstanding loan balance that limits the amount of new borrowing available.  The CRD may also be the better option if the employment associated with a 401(k) may be at risk.

Pros:

• If the distributed amount is rolled over back into your retirement plan, there are no taxes.
• If the distributed amount is not rolled over, the tax implications are less than would normally occur with an early distribution, and you have 3 years to pay the taxes.
• Available to all plan participants, not only those with an active 401(k) plan.

Cons:

• Must have qualifying conditions for the distribution.
• Need to pay taxes on the distributed amount unless rolled over in 2020.
• Need to amend tax returns to reclaim taxes paid.

Rollover as Business Startup

You can use eligible tax-deferred retirement savings to directly invest in your own business with no limit on the amount and no taxes or penalties.  To accomplish this, a strategy we call a Business Funding IRA is used.

As with the rebound period after the great recession of 2008, we expect a surge in the use of this special vehicle in coming years as more and more investors decide to tap retirement savings to start, salvage, or grow their own business.

The concept is often referred to as a Rollover as Business Startup or ROBS plan but is not just for startups.  The plan can be applied to both new and existing business ventures.  The ROBS structure works as follows:

• The operating business must be a sub-chapter C corporation.  If the business is currently in another format, it must change to this entity type.
• The business establishes either a profit sharing or 401(k) style retirement plan, depending on which is more suitable to the situation at hand.
• As an employee/owner of the business, you can rollover funds from a prior employer tax-deferred 401(k), IRA or similar plan.
• The company retirement plan then purchases shares of the parent corporation using an employee stock option purchase (ESOP).
• The plan is now a shareholder of the business, and the plan capital is available to the business for startup, expansion, or other legitimate business capital needs.  You can even pay yourself a salary.

There are no taxes associated with this strategy.

There is no limit on the amount of funds you can rollover, so it becomes possible to tap much more than the $100,000 cap associated with a participant loan or CRD.

Because of the administrative infrastructure required for this plan, we do not recommend this solution for rollover amounts of less than $100,000.

Pros:

• A means to invest in yourself.
• No cap on the amount of funding available.
• No need to repay in either 3 or 5 years as with the other options.
• Funds can be used for any legitimate business purpose.

Cons:

• A more complex solution only suitable for larger capital amounts.
• Cannot access a current employer 401(k) for rollover.
• Cannot rollover a Roth IRA into this plan.
• Plan benefits including stock ownership must be made available to all eligible employees of the business.

You Can, but Should You?

We have illustrated several means available to tap retirement savings as a way to salvage or grow a business.  Whether any of these strategies is a good idea for your particular circumstance is a complex matter.

There is always risk in running a business and investing in yourself, but that risk is magnified dramatically in the current environment.  There are a lot of questions still very much unanswered about how quickly we can expect an economic turnaround and what kind of upward curve to expect.  The results are sure to be uneven across different locations and business types.

Losing a business you have spent time, capital, and heart to build could be painful.  Losing that business and your retirement nest egg along with it would be far worse.  Throwing good money after bad is never a good strategy.

Before you consider any of these options, be sure to perform the best diligence you can and consult with your licensed counsel with respect to the future prospects of your business venture.