Rollover for business startups: Fund your business with a 401(k)

Raising money to launch a small business can be challenging because lenders don't typically offer loans to new ventures. Generally, you need at least 1 to 2 years of business operation to qualify. Many lenders also require a minimum annual revenue, which can range anywhere from $50,000 to $250,000.

A rollover for business startups, or ROBS—which allows you to tap the money in your 401(k) or another retirement plan for seed capital to get your business off the ground—may help you overcome these hurdles and turn your business plan into reality. Here's how this strategy works, along with the pros and cons.

ROBS basics

In a ROBS, you use savings from a retirement plan, like a 401(k) or a traditional individual retirement account, or IRA, to finance the launch or the purchase of a small business. It's not a taxable withdrawal from your retirement plan. Instead, you use the retirement funds to buy shares of stock in the small business.

It's important to note you can only fund the company using a pretax retirement account like a 401(k) or a traditional IRA. A Roth IRA or Roth 401(k) won't work.

For this strategy, the business must operate as a C corporation—a business structure where you can buy stock. Then, set up a 401(k) plan for your new business and transfer your retirement balance into it. Finally, use that cash to buy shares of the C corporation.

Your small business will then have the cash in its bank account to cover payroll— including your salary—rent a building, buy or lease equipment and handle other expenses. In exchange, you'll own shares of the small business in your retirement plan. So if it succeeds, these will grow in value.

ROBS benefits

Rollovers for business startups were created for a reason, and many business owners have taken full advantage for the wide range of benefits they can bring.

• Access to financing: Raising money for a new small business can be a catch-22 because you need money to get started, but lenders usually want to see a proven track record of at least a year of revenue before offering financing. With a ROBS, you can get your business off the ground so you can qualify later for other sources of financing, like US Small Business Administration loans.
• No withdrawal penalties or taxes: With ROBS, you can use your retirement funds without worrying about owing income taxes. You also won't owe the 10% early withdrawal penalty, even if you're younger than 59 1/2.
• No debt: A rollover for business startups isn't a loan, which means you don't have to pay interest out of your business cash flow either to your 401(k) or an outside lender. It also means you won't leave with debt if you close the business.

ROBS drawbacks

As with any financial plan, there are inevitable drawbacks. The same goes for ROBS, so it's important to consider the downsides to make sure it's the best choice for you.

• Risk to your retirement funds: Starting a new business is already a significant risk. If you fund it using your retirement savings and the business fails, you may set back your financial goals significantly. Although your savings are tied up in the business, you aren't investing and seeing growth from the stock market.
• Costly setup and operation fees: A ROBS isn't cheap to set up. The provider will charge an upfront fee of several thousand dollars to get started, then you'll owe a monthly fee for their management of the 401(k) and paperwork.
• C corporation status required: This strategy only works with C corporations, which can be expensive to launch and have more complicated tax rules than other options, like an LLC or partnership.
• IRS scrutiny: The IRS watches out for small businesses being run through a ROBS to make sure they're following the proper business tax guidelines. Your business may be more likely to be audited, and if you didn't set up your ROBS properly the IRS could shut down your retirement plan, forcing you to owe extra taxes and penalties on the value of your account.

ROBS management

If you'd like to set up a ROBS, there are many rules you need to follow. Among the most important to recognize are those related to employment and compensation. You must work for the business and pay yourself a salary, but the salary must be reasonable for the work you're doing—in other words, what you would have paid to someone else if you hired them for the role.

If you hire other employees, they must have the opportunity to participate in the 401(k). They don't need to, but be prepared to prove to the IRS that you offered the plan. This then raises questions of eligibility and state and federal laws, which you'll need to investigate. Furthermore, you can't use the ROBS funds to buy assets you could also use personally, like a company car.

The bottom line

Retirement doesn't need to be the end of your business life. In fact, through a rollover for business startups, you might discover an entirely new beginning—one that aligns more closely with your passions. Just be sure to carefully consider the ground before committing to the path.