So, you have an idea for a business venture. The next step is to secure some startup capital so you can begin forming your business. But, as any entrepreneur knows, cash can be hard to find. If you’re transitioning from employee to entrepreneur, you may be interested in your options for liquidating your 401k/IRA for use as startup capital. After all, you may have a lot of money in those plans. And it’s yours, right? So, you should just be able to take it out and start spending it? Unfortunately, this is not the case.
If you wish to liquidate funds from your retirement plan, you have three options. The first option is to take out a loan against those funds. This can be wise, since the interest you pay on the loan goes into your retirement funds, so you essentially pay interest to yourself. However, the ability to take out a loan against your retirement funds is dependent on the rules of your retirement fund plan. You can only do it if your employer/plan administrator lets you. Alternatively, you could just withdraw your funds early (assuming you are younger than 59.5). Unfortunately, this option is just plain bad, since you will pay a hefty 10% fee for early withdrawal. In addition, from the IRS’s perspective, you also receive all that money as taxable income in the year you withdraw early, meaning that you take on a LOT of tax liability.
So, what about that third option? Enter the Rollovers as Business Startups (ROBS) plan. A ROBS plan can allow you to utilize your retirement funds as startup capital. You can avoid a loan and any penalties for early withdrawal. Let’s first explore the process for creating a ROBS plan, then we can investigate the pros and cons of this option.
The Method:
A ROBS plan is conceptually uncomplicated. You first form your new business as a C-Corporation: the standard American corporate model. Next, you form a 401k plan for that corporation, name yourself as an employee of the company and beneficiary of the plan, and rollover your fund from previous retirement plans into this new plan, as you could anytime you started a new job. Then, that new 401k ROBS plan buys stock in your corporation. The proceeds from the stock sale can then be used by the new corporation as startup capital.
The Pros:
The process of forming a ROBS plan, if done right, enables the liquidation of retirement assets without early withdrawal penalty, loan payments, or tax liability. Securing startup capital is a mountainous challenge for most entrepreneurs. Venture capitalists and other investors are unlikely to invest in your project if you can’t first demonstrate an investment of your own money – a vote of personal confidence in your idea. If you don’t have a nest egg laying around for this purpose, that startup capital mountain just became an impenetrable castle wall. You may need to liquidate your assets, and your retirement plan funds are a significant asset. This makes the ROBS plan an extremely attractive option.
The Cons:
Unfortunately, there are quite a few downsides to using a ROBS plan. The first one is obvious: you are risking your retirement on your business idea. If the company fails, you will probably lose significant portions of your retirement savings. On this basis alone, the utilization of retirement funds for startup capital should probably be a last resort.
However, there are other problems with the ROBS plan. In order to institute a ROBS plan, you have to form your business as a C-Corporation. You can’t use an LLC or any other business entity form. C-Corporations require formal management systems: you will need company bylaws, a board of directors, to prepare annual filings, etcetera. These formalities make C-Corporations unattractive to entrepreneurs who want to manage their business on their own and in their own way. In addition, C-Corporations are subject to the corporate double tax. The new company will be expected to file its own tax returns and pay income taxes (as well as other corporate taxes). If the company issues dividends, the company pays taxes on the income from which those dividends are derived, AND the shareholders pay income taxes on the dividends they receive – double taxed.
Another downside of the plan is the annual filing requirements. ROBS plans are new 401k plans. The plan administrator will have to file the annually required forms on behalf of the plan, including the Form 5500, which summarizes the annual status of the 401k plan. These filing requirements can be a serious hassle, especially for small businesses which are trying to focus on daily operations.
As a final note, ROBS plans face significant IRS scrutiny. The ROBS plan enables the taxpayer to dodge tax liability while liquidating retirement assets, and the IRS will ensure that the plan is formed and administered properly. If it appears that the ROBS plan is operating like a bank account instead of as a proper retirement plan, the IRS may become suspicious, and the resulting investigation will be a major disruption for your business. Be careful to follow the rules in forming and administering your ROBS plan.
The Takeaway:
So, is a ROBS plan the way to go in securing some startup capital? The answer is going to depend on the situation of you, the entrepreneur. As discussed above, the plan is an option for liquidating retirement funds without incurring early withdrawal penalties, tax liability, or loan payments. However, there are tradeoffs to this plan. Prospective entrepreneurs should seriously consider whether the risk of forming a ROBS plan are worth it for the cashflow. Other options, such as bank loans or crowdfunding, may be more desirable.
Image Credits:
401k Graphic (Adobe Stock Photo) – https://www.theastuteadvisor.com/401k-plans/
ROBS Plan Graphic – https://psu.pb.unizin.org/expsk909/chapter/using-401k-retirement-money-for-seed-funding/
Sources:
https://psu.pb.unizin.org/expsk909/chapter/using-401k-retirement-money-for-seed-funding/
https://www.irs.gov/retirement-plans/rollovers-as-business-start-ups-compliance-project
https://www.irs.gov/pub/irs-tege/robs_guidelines.pdf
https://www.lendingtree.com/business/robs/
https://www.nerdwallet.com/article/small-business/rollovers-as-business-startups-robs
https://www.guidantfinancial.com/401k-business-financing-robs-guide/