How to Use a ROBS 401(k) to Finance a Business

Desy Papper

A young female entrepreneur It takes money to start and keep a business running, and access to capital is one of the major roadblocks to business ownership for many would-be entrepreneurs. However, there are several ways individuals can use their retirement funds to finance a business. A Rollover for Business […]

A young female entrepreneur

It takes money to start and keep a business running, and access to capital is one of the major roadblocks to business ownership for many would-be entrepreneurs. However, there are several ways individuals can use their retirement funds to finance a business. A Rollover for Business Startup (ROBS) lets a current or prospective business owner tap a 401(k) or IRA to finance a startup, acquisition or refinance a business. Because it’s imperative to exercise caution when putting your retirement assets on the line for pre-retirement initiatives be sure to work with a financial advisor before you take action.

ROBS Basics

A ROBS arrangement allows an individual to roll over assets from an existing retirement account, like a 401(k) or an IRA, tax-free. Then the funds can be used to buy stock in the new business, providing capital for startup or expansion.

ROBS offers a number of potential advantages over other ways of funding startup businesses. The benefits can open business ownership up to more people, and also potentially improve the success rates of new firms. Benefits include:

  • Using ROBS for financing instead of personal savings conserves cash.

  • A ROBS arrangement is not a loan, so it avoids the need to take on debt to pay for a startup.

  • There is no need to qualify for a loan, even if a would-be entrepreneur has poor credit.

  • Without the requirement to make loan payments, the business will have better cash flow.

  • ROBS funds don’t have any built-in costs because no interest payments are required.

ROBS funds can be used for any business-related expense. This includes paying salaries to employees or to the owner.

A ROBS can be a better alternative than a business startup loan but, especially for businesses that need more money than the owner has in his or her retirement account, it can also be paired with a loan. The cash from the ROBS rollover can be used to satisfy the common lender demand that the owner inject a certain amount of his or her own funds in the business in order to qualify for the loan.

ROBS Requirements

A startup financed with a ROBS

A startup financed with a ROBS

ROBS arrangements are best suited for business owners who, because they have poor credit or otherwise lack access to other sources of capital, are unable to finance business startup any other way. Taking money out of a retirement account can have potentially serious consequences down the road, when the business owner wants to retire and finds retirement savings are inadequate. So using a ROBS requires careful consideration.

Beyond that, the requirements for a ROBS include:

  • Having a qualifying retirement plan. Not all plans can be used as sources of ROBS funds. For instance, Roth 401(k) plans don’t qualify.

  • Obtaining permission from the plan administrator. Not all plans allow ROBS rollovers.

  • You need at least $50,000 to start the business. That’s because a ROBS plan costs a lot to set up and there are significant ongoing legal, accounting and administrative fees.

  • You are going to work in the business as an employee.

ROBS Steps

Performing a ROBS rollover calls for a lot of preparation, often starting with organizing or re-organizing your business entity. Here are the required steps:

  1. Incorporate your business as a C corporation. This is required because only corporations can sell shares to investors, and the ROBS works by using retirement funds to buy shares in the business. A sole proprietorship, partnership, LLC or other entity won’t work.

  2. Organize a 401(k) retirement plan for business employees. This can require retaining a custodian to oversee the plan.

  3. With the assistance of the administrator of your existing retirement plan, conduct the rollover of funds from your existing retirement plan into the new 401(k) plan for the new business.

  4. Use the funds in the new 401(k) to buy shares in the corporation. This will inject the funds into the business.

The ROBS-related work isn’t finished when the business is funded. The IRS requires a number of ROBS-related forms to be filed, including the annual Form 5500 or 5500-ES. There are restrictions on how much the owner’s salary can be. And any eligible employees also must be allowed to purchase shares in the company, just as the ROBS 401(k) did.

ROBS Risks

401(k) piggy bank

401(k) piggy bank

When the IRS did a study of ROBS plans, the findings were grim. Most ROBS-funded businesses wound up failing, ending in business or personal bankruptcy and eventual dissolution. While the same is true of most businesses, the ROBS-funded business owners also lost some or all of their retirement savings. Entrepreneurs who fund unsuccessful startups with loans, on the other hand, can hang onto their retirement accounts and often use business or bankruptcy proceedings to avoid having to pay back loans to their failed businesses.

ROBS Alternatives

As an alternative to ROBS, entrepreneurs can borrow from their 401(k) accounts. This is best for businesses that need less than $50,000 to start and are confident of being able to pay the loan back. It can help business owners whose credit history is too poor to let them qualify for a loan.

But a 401(k) loan only works if the entrepreneur’s existing retirement plan allows loans, and many do not. There is also a maximum of $10,000 or 50% of the retirement plan balance, which either is largest. Finally, if an entrepreneur voluntarily or involuntarily stops working at the employer sponsoring the plan that gave out the loan, the funds have to be repaid or risk being treated as an early withdrawal, with significant consequences including a 10% penalty and immediate payment of any income taxes.

Another option for older entrepreneurs may be to withdraw from their retirement plans. Those over age 59 and a half can do without having to pay the 10% penalty. Withdrawals still incur regular income taxes. But, since they aren’t loans, entrepreneurs aren’t on the hook to make repayments or pay interest.

Bottom Line

ROBS can help entrepreneurs who lack other financing options use their retirement funds in a tax-free transaction to fund a new business, refinance or make an acquisition. ROBS work best for amounts over $50,000 and can involve significant initial and ongoing complexity and cost. They are also risky, since if the business fails the entrepreneur will have lost some or all of the money intended to fund a secure retirement. Finally, be sure to carefully weigh the pros and cons to ROBS alternatives.

Tips on Financing Business

  • Using a ROBS is a tempting, potentially low-cost way to fund a new business, but the process is complicated and requires knowledge of detailed requirements to make sure the process is done in accordance with the rules. An experienced financial advisor can help to make sure an entrepreneur is using ROBS the right way. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready, get started now.

  • Don’t forget about the value of plain old-fashion savings as a way to finance a startup. Our savings calculator can tell you how long it will take you to reach your goal.

Photo credit: ©iStock.com/Ridofranz, ©iStock.com/Dan Rentea, ©iStock.com/TK

The post How to Use a ROBS 401(k) to Finance a Business appeared first on SmartAsset Blog.

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