How to Use Your Retirement Account to Start or Buy a Business: A Guide to ROBS Financing

With bank loans hard to come by, a lot of people are turning to a more personal source for business capital: their retirement accounts.

How does this work? What’s the cost? Is it worth it to risk your nest egg? Here’s what you need to know about funding your business with your retirement account.

Funneling Retirement Funds Into a Business: Two Options

There are two ways to use retirement money for your business. If you have at least $50,000 saved up in your retirement account and need that much or more for your business, the best option is “Rollovers as Business Startups” (ROBS).  For smaller amounts, consider taking a loan from your retirement plan.

Rollovers as Business Startups (ROBS): This option allows you to transfer funds from your personal retirement account to your business without paying early withdrawal penalties or income taxes. Here’s how it works:

1. You must hold money in a qualified retirement account, such as a 401(k), 403(b), 457(b), or traditional IRA.
2. Begin a new C Corporation; if buying an existing business, change its ownership structure to a C Corporation if it’s not already a C Corp.
3. Have the new business create a company-sponsored retirement plan, such as a 401(k) or profit sharing plan; the plan must be open to all eligible employees.
4. Transfer funds from your personal retirement account into the company-sponsored retirement account.
5. The company-sponsored retirement account then purchases stock in your business. You use the money from the sale to fund your startup, buy the business, or recapitalize an existing business.

A ROBS transaction is not a loan, so it’s a good option for funding your business without incurring debt or having to pay interest. However, the fees make it a viable option only if you are planning to roll over at least $50,000.

If the five steps seem complicated, that’s because a ROBS can be complicated! In order to avoid early withdrawal penalties and income taxes, you can’t run afoul of legal or tax codes. It’s best to get help from a financial company that specializes in ROBS. For more information, check out this complete guide to ROBS financing.

Retirement Plan Loan: The second, simpler option is to take a loan from your 401(k) account or other retirement plan (not possible with IRAs). Many employers will allow employees to take loans from their retirement plans, but may place restrictions on what they can do with the money. For example, they may specify that the money can be used to pay for your kid’s college or for a home, but not to start a business.

If your employer allows plan loans for starting a business, this may be a good option for you. Like a ROBS, a retirement plan loan allows you to avoid income tax and early withdrawal penalties. Unlike a ROBS, however, you can only borrow up to half of your retirement account balance or $50,000, whichever is less.

The money must typically be repaid within five years, and interest is charged on the loan. However, you pay the interest and principal back into your own retirement account, not to a third party.

What’s the Cost?

ROBS: Since a ROBS is not a loan, you do not incur debt or pay interest. A ROBS does carry an initial fee and ongoing fees, however. The initial setup cost is about $5,000, and the ongoing fees are around $1,500/month. Because of the fees, it really only makes sense to do a ROBS if you plan to rollover $50,000 or more.

Retirement Plan Loan: When you take out a 401(k) loan or other plan loan, your plan administrator will charge an interest rate. The interest doesn’t go to the plan administrator; Over the next five years or whatever the loan term may be, you pay back the principal plus interest into your own retirement account.

At this point, you may be wondering if a plan loan costs anything. The answer is yes. The effective cost of a plan loan can be viewed in terms of the potential loss in retirement savings.

This loss can come from different directions. Because you need to repay the loan, you may compensate by decreasing the amount you contribute each month to your retirement account. You may not pay yourself back the same amount you would have earned if you left the money untouched (i.e., you pay yourself back at 6% interest, but you may have been able to earn 10 % interest if you had kept the money invested in your retirement plan.).

Finally, whereas regular contributions are made with pre-tax dollars, taking a plan loan essentially means you get taxed twice. The loan repayments are made with after-tax dollars, and you get taxed again when you withdraw money from your retirement account upon reaching retirement age.

Some plan administrators charge a setup fee that ranges from approximately $50-175, as well quarterly loan fees of $25-50. Unlike interest payments, the fees go to the plan administrator, not back to you.

Is It Worth the Risk?

Whether you choose a ROBS or a plan loan, you run the risk of your business failing and wiping out your hard-earned retirement funds. So ultimately, the question of whether it’s worth it is one that only you can answer after weighing the pros and cons.

ROBS
Pros:

• No taxes or early withdrawal penalties.
• No limit on how much you can roll over.
• No debt on interest payments.
• Your business profits grow in a tax-advantaged company retirement account.
• You have more control over the growth of your retirement money because you run your business on a day-to-day basis.
• Can be used to fund a startup or other situations where you can’t qualify for other types of funding.

Cons:

• If your business fails, you will lose the money you rolled over.
• You must administer a retirement plan for your employees.
• Because of the complexity of the transaction, you run a higher risk of being audited by the IRS. Fortunately, the top ROBS providers are very competent and can help minimize the risk of audits.

Retirement Plan Loan
Pros:

• No taxes or early withdrawal penalties unless you don’t pay back the loan.
• You pay yourself back instead of owing money to a bank.
• Plan loans often carry lower interest rates than standard bank loans.
• You can usually use the loan to start, buy, or recapitalize a business (some plans have restrictions on how the money can be used).

Cons:

• Small amount of capital: you can take out a loan that’s half of your retirement account balance or $50K, whichever is less.
• Not offered by all employers, and some employers may place restrictions on how you can use the funds.
• Interest is charged, and you have to watch out for loan fees such as origination fees and administration fees.
• You may end up saving less for retirement than if you had kept the money invested in your plan.
• If your business fails, you may have difficulty repaying the loan; if you can’t pay it back, the loan is considered a distribution and taxed as income, plus a 10% penalty is charged if you’re under 59½.
• If you don’t make a payment for 90 days, you face the same financial penalties.
• If you quit or are let go from your job, you must repay the entire loan within 60 days or face the same financial penalties.

The biggest risk with either financing option is the possibility of losing your savings and not having enough money to retire. You have to be realistic about this risk and have a plan B in case in your business doesn’t work out as planned. If you have a backup, using your retirement funds to start or buy a business may be a great choice.

The post How to Use Your Retirement Account to Start or Buy a Business: A Guide to ROBS Financing appeared first on AllBusiness.com

The post How to Use Your Retirement Account to Start or Buy a Business: A Guide to ROBS Financing appeared first on AllBusiness.com.