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The Basics of 401(k) Financing

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What it is: It is actually possible to fund a startup or buy a business with money from a previous employer's 401(k) plan or your own Individual Retirement Account. And you don't need to pay extra taxes to do it.

How it works: The federal government's Employee Retirement Income Security Act (ERISA) allows people to roll over existing IRA or 401(k) plans into a plan created for a new business. Thousands of Americans have already used this strategy, with the practice especially popular among franchise purchasers.

For an upfront fee of a few thousand dollars, companies including Bellevue, Wash.-based Guidant Financial, North Wales, Pa.-based Benetrends, and Huntington Beach, Calif.-based SDCooper Co. will create a retirement plan for your new business that happens to also invest most of its funds in the business.

Basically, you just made your 401(k) plan an investor. You can start writing checks off the investment, without having to pay extra taxes or early withdrawal penalties.

Related: Should You Tap Your 401(k) to Start Your Business?

Upside: This is your own money -- saved for your retirement. Unlike other forms of startup financing, there are no interest rates, bossy investors, or friends and relatives asking when you're going to pay them back.

Downside: This is your own money -- and it was supposed to pay for your retirement. If the business goes under, prepare for some bleak sunset years.

This is not a do-it-yourself financial transaction, either. You are setting up a corporate retirement plan with all the IRS rules that go along with one, including the need to file regular reports, diversify investments and offer the plan to eligible employees. Besides the few thousand dollars up front, you'll be stuck paying annual fees to a third party to ensure that you are following the rules and not running afoul of the IRS.

Starting out, compliance will be easy if you are the only employee and the value of the business is low. But that will change over time as the business grows and you bring on employees.

Related: 4 Alternative Funding Sources

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