Should I Use a 401(k) Withdrawal to Pay Off Business Debt?

You probably should not. While it may be tempting to tap your retirement savings to help your business, withdrawing from your retirement fund early comes at a high cost and can leave you financially vulnerable in your later years. You will be more flexible and have more options by preserving the 401(k) money. The bigger reason: a 401(k) is one of the best-protected assets you own. Business creditors usually can’t get to it, but once you withdraw the money, it’s in play. Don’t let panic drive you to abandon it.

Safe from Creditors

Your 401(k) is an ERISA retirement plan, which is protected from creditors under the Employee Retirement Income Security Act of 1974. As a result, it is not included in your bankruptcy estate and is safe from creditors. This means a creditor cannot touch your 401(k) in the event that you get sued, file for bankruptcy, or experience another difficult situation that requires you to pay off a large amount of debt. 401(k) accounts are subject to federal law, so they are off limits to creditors wherever you live. Also, it doesn’t matter how big the account is. The only debts that can touch your 401(k) are those resulting from unpaid federal taxes, a divorce, or federal criminal restitution. In the event that you owe back taxes, the IRS can seize your 401(k) to satisfy a tax lien. Additionally, an “ex-spouse” can take a portion of your retirement assets in the form of a Qualified Domestic Relations Order or a QDRO.

Note that the above only holds true for ERISA retirement plans, such as the employer-sponsored retirement plans that many people receive through their jobs. A solo 401(k) is an individual 401(k) that you can establish as a self-employed person. A solo 401(k) is not protected from creditors under ERISA. If you file for bankruptcy, however, solo 401(k) accounts are fully exempt, with no dollar cap. But whether you can protect a solo 401(k) outside of bankruptcy will depend on the state laws that you live in.

Repercussions to Withdrawing Money from Your 401(k)

Once you pull money out of your 401(k), it is no longer protected under ERISA. States often have different laws that govern how protected your 401(k) money will be after withdrawal. Some states will protect the 401(k) money from creditors as long as the money can be traced to the original retirement plan, but some states will treat the money as an ordinary asset that can be seized by creditors. Furthermore, if you mix your 401(k) money with your other money in one checking account, it can be very difficult to prove which is which and thus protect the 401(k) money. To protect retirement money, you should deposit the money into a separate account as quickly as possible. You should not allow the money to mingle with any other assets, and you should avoid moving it from one account to another. Each move weakens the argument that the money is still retirement money.

Additionally, there are other repercussions to withdrawing money from your 401(k) before age 59 1/2. The withdrawal will be considered an “early withdrawal” and subject to income taxes as well as a 10% penalty. You won’t walk away with as much as you might expect. That’s because federal law requires the plan to withhold 20% of the distribution for federal income tax, and there’s no way to opt out.

Alternatively, you may be able to ask the plan administrator for a hardship withdrawal. A hardship withdrawal is a formal withdrawal made due to certain approved needs. You will still have to pay income taxes on the withdrawal, and you may still have to pay the 10% penalty. The money can never be paid back into the plan. The IRS has an emergency exception, but you can only tap $1,000 a year.

Another option is to take a loan from your 401(k). You may discover your 401(k) plan doesn’t have to offer loans, and IRA plans never can. If your plan allows loans, you can generally borrow the lesser of 50% of your vested 401(k) account balance or $50,000. The loans must be paid back in full with interest within five years, although a loan used to purchase your primary home may be for a longer period of time. Once a plan does allow loans, you must repay them at least quarterly. If your business can’t keep up the payments, the loan defaults and gets taxed.

Lose Money Twice

If you decide to tap your retirement savings to help your business and the business still fails, you will find yourself in a difficult financial situation. You will lose money twice, once with the business and then again with your retirement savings. The exemptions for retirement don’t apply to business assets, money in bank or brokerage accounts or home equity. Once you’ve moved funds from your retirement accounts into the business, you’ve lost that protection. If you end up filing bankruptcy, your 401(k) would have stayed outside the bankruptcy estate. If you withdraw it now, you’re handing creditors money they could not otherwise take. You need that money even more if the business falters.

When your assets are at risk of being seized by creditors, it is in your best interests to preserve as much as you can. As a general proposition, if you roll your 401(k) into an IRA, you are switching federal ERISA protection for whatever IRA protection your state provides. Some states give IRAs complete protection. Others don’t. As for old 401(k)s from past jobs, you may be better off leaving them in their present employer’s plan, or moving them into a new employer’s plan, where ERISA law may protect them. Keep the money where it is safe and protected.