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Using Your 401(k) to Start a Business: Proceed with Caution

Capitalizing a new company with retirement funds is an option – but one fraught with technical complexities and the added risk of wiping out precious savings

If you are thinking of starting a business, being properly capitalized is essential to your survival and success. Despite your many years of experience in your chosen industry or trade, in these still-uncertain economic times you cannot count on getting a conventional bank or SBA loan.

Fortunately, you might have a source of capital that you had not considered, one that allows you to put your years of hard work and savings to use: tapping into a 401(k) plan to open a “Rollover as Business Start-Up.” Through a “ROBS,” you can use all or part of your 401(k) without incurring the typical 401(k) income taxes and, if you’re younger than 59½, 10% early withdrawal penalty.

However, as Reuters notes, the ROBS opportunity is complex, and it comes with strict rules and regulations that you must follow or run afoul of the IRS. If you are considering a ROBS, it's important that you understand the strategy — and its risks — clearly.

How a ROBS Works

When you take money out of your 401(k) for a ROBS, you must use it to create a C corporation. As you may know, that form of entity is significantly different from, and more complicated than, the more commonly used S corporation or limited liability company (LLC).

Your new C corporation sets up its own 401(k) plan, and it must offer employees (including you) the option to buy stock in the new company. You then roll over the money from your 401(k) into the new corporation‘s plan. You can then use the newly rolled-over 401(k) monies to fund your new company. Essentially, it’s tax-free working capital.

Details

“Tax free” doesn’t mean “headache free,” though. With a ROBS, you have to satisfy not only the IRS but also the U.S. Department of Labor, which holds jurisdiction over 401(k) plans. (As any employer who has ever run afoul of the Labor Department can readily attest, that is a life experience that you should avoid at all costs.) Failure to dot the i’s and cross your t’s could lead to penalties or having the retirement plan disallowed, resulting in a potentially huge tax bill.

To handle the formation of your ROBS corporation and its retirement plan, you should use an attorney or CPA who is familiar with the Employee Retirement Income Security Act (ERISA), which regulates employee benefit plans.

Another option is to borrow against your 401(k), but the loan is capped at $50,000. If your business needs are greater than that, you would probably be better off taking the money out and paying income taxes and a penalty if necessary. Under that approach, you could set up an S corporation, which allows any business losses to flow through to your personal tax return. That advantage is not available with the C corporation required under a ROBS.

Nest Egg at Risk

A ROBS-funded company is vulnerable to the same business mortality risks as any other company (e.g., only half of new businesses survive to their fifth year, dropping to one-third by year 10, according to the U.S. Bureau of Labor Statistics).

In addition to understanding the technical, legal and regulatory aspects of a ROBS, be sure to assess your personal risk tolerance, with specific attention to the impact on your retirement and your estate should your business fail and wipe out your 401(k), and your ability, at your current age, to recover lost savings in time to enjoy your retirement years.

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