If your ready to transition for employee to entrepreneurship, once you decide what you want out of life the next thing you need to do is figure out how your going to pay for it. If you have significant money in your 401(k) or IRA and now your ready to turn your side hustle into a full-time business, you can use the money in your retirement account as capital for your business without incurring a tax bill. But you must follow the rules carefully, or you could end up with IRS trouble and no retirement nest egg.
Rollovers as Business Startups (ROBS)
Rollovers as Business Startups (ROBS) is a way to use the money in your retirement account to fund your start up business. If you have a 401(k) or other qualified retirement plan with a balance that’s sufficient for you to use to invest in your business, it’s a good potential option.
To establish a ROBS account, you must first incorporate your new business as a C-Corp and then set up a qualified retirement plan for that business that can buy private stock. Then you roll over your 401(k) or other retirement account to the new retirement plan. You can do the rollover is tax free. That plan then buys shares in your corporation. Essentially the retirement plan becomes an owner of your business.
Benefits of using ROBS
- You Become Your Own Bank. This is a way to self fund your business. You won’t need credit approval or to pitch any investors on your business idea. There are no collateral or minimum credit score requirements to qualify for ROBS, so it’s an ideal option for many business owners, regardless of credit history.
- Fast Funding. You can gain access to your retirement funds in as little as three weeks. Once the ROBS transaction is complete, the cash can immediately be used as a down payment.
- Avoid Tax Penalty on Retirement Funds. In order to use the funds in your 401K without doing the rollover, the distribution from the 401(k) or retirement plan would be immediately taxable.
- Combining SBA loans with ROBS for financing. This can work well for many new business owners. SBA loans typically require a 20 – 30 percent down payment. Rather than using savings, many entrepreneurs leverage ROBS as an alternative way to manage a larger down payment on a business loan.
- Reduce Risk to Lender. Using retirement funds allows for a larger down payment — reducing your risk to the bank lender and making you a more qualified, confident borrower.
- Increased Buying Power. With a bigger down payment, borrowers have more funding options when launching or buying a business and can often negotiate a better interest rate.
Downside to ROBS. There are significant risks to this approach.
- Your Retirement Savings is At Risk. You are betting the farm on your business idea, so you better do your homework on the market, your target customer and be sure you have a value proposition. Since you are betting the farm on your business you better have a clear path to profit. If the business fails, which they often do, you could lose your retirement savings.
- Increased IRS scrutiny. ROBS can be disqualified by the IRS if they are not properly administered. If the IRS can successfully challenge the ROBS, all of the funds rolled over would be a taxable distribution.
- Annual filing. Qualified retirement plans, such as the new plan set up in the ROBS, are required to file an annual information return in the 5500 series. There is an exemption in the requirement to file if the assets of the plan are less than $250,000. However, this exemption does not apply to ROBS.
- Costs. You should use a company that specializes in ROBS. Such a company usually charges a hefty fee for helping to set up and administer the arrangement. And there’s annual reporting for the plan.
QUALIFYING FOR ROBS IS EASY
If you meet these simple requirements, you’re a great candidate for ROBS:
- Funds in a qualified retirement account, including 401(k) (you cannot be currently employed by sponsoring company), traditional IRA, TSP, 403(b), Keogh, SEP (Roth IRAs do not qualify).
- Balance over $50,000 in rollable retirement funds, meaning the funds must be able to be moved from one tax-deferred retirement account to another.
- The company must be set up as a C corporation. The company funded must be an active, operating company (cannot be a passive investment)
- The new business must sponsor a retirement plan, usually a 401(k).
- The borrower must work in the business and take a salary.
Using ROBS has many benefits, especially when combined with traditional funding methods such as SBA loans. It’s ideal for those who can’t afford or don’t want to pay their down payment out-of-pocket. If you are considering a ROBS, be sure to have your own financial planner and or tax advisor review your program to keep things compliant as an IRS audit is certainly not out of the question.
It may be tempting to use funds in retirement plans to fund or buy a business. But your business venture may not work out. You could face a significant tax bill, and even worse, lose your retirement savings. Proceed with caution.