Thinking of taking the plunge into entrepreneurship? For many people, the hardest part is not coming up with a business idea or a potential business to buy, but finding the capital needed to start or buy the business. Too often, an entrepreneur doesn’t even know that using retirement funds could be an option for investing in a new business.
Startup Capital
The first place entrepreneurs typically start when looking to fund a startup is personal savings. If they do not have sufficient personal savings, then third-party loans, such as Small Business Association loans, or home-equity loans are a popular option. However, if acquiring a loan is not viable for you, then seeking third-party investors or crowdsourcing funding is often the last resort.
Unfortunately, in my experience, far too many entrepreneurs are not aware that the use of a retirement account as a business funding source could end up being the most tax-efficient option.
Understanding the Basics
Retirement accounts, such as 401(k) plans and Individual Retirement Accounts (IRAs), are designed to provide you with financial security during your retirement years. Withdrawing funds from these accounts before retirement can lead to hefty penalties and tax implications. However, there are paths that allow you to tap into your retirement savings to fund your business without incurring these penalties.
The Rollover as Business Start-Up (ROBS)
One popular method to utilize your retirement funds for your business is through a structure called Rollover as Business Start-Up (ROBS). This strategy allows you to use your existing retirement savings to invest in your new venture without triggering taxes or early withdrawal penalties. The structure does have a variety of requirements and moving pieces so keep reading before you jump in. Here’s how it works:
1. Set Up a C Corporation:
ROBS requires that you establish a C Corporation. This is because the funds can only be directed into a corporate structure that allows stock ownership. This will not work with a limited liability company. A change to another business entity could result in a taxable distribution on your rolled-over funds.
2. Roll Over Existing Retirement Funds:
You can roll over funds from an eligible retirement account, such as a 401(k) or an IRA, into a new retirement plan that you set up for your C Corporation.
3. Purchase Stock:
Once the new plan is funded, the corporation can purchase stock in the C Corporation, providing you with a cash infusion to fund your startup. However, the rules require that your retirement plan pays Fair Market Value (FMV) for stock purchased by your C corporation for the plan. Because of this requirement, ROBS are ideal for use in purchasing an existing business. The fair market value of that business is more easily appraised or defended in the event of an audit. ROBS are less useful for pure start-ups where you have no product, service or revenue to justify the purchase price of the stock.
Pros and Cons of ROBS
Pros:
Access to significant capital without incurring penalties or taxes.
The ability to fund your business with your own money, minimizing the need for loans or investor funding.
No monthly repayments, which can alleviate financial pressure during the startup phase.
Cons:
Complexity: Setting up a ROBS involves adherence to strict IRS regulations and may require professional assistance.
Risk: If your business fails, you may lose your retirement savings.
Ongoing Compliance: The C Corporation must adhere to IRS regulations, leading to ongoing compliance requirements.
Not useful for passive investment type businesses. The rules require the business to be an operating company. Most businesses and franchises meet these operating criteria. Business ventures that are eligible don’t include lending, investing, or single investments in real estate. Real estate does present a grey area: you can fund a property management or real estate operating company, but qualifying as “operating” depends on the scale of the venture.
Other Options to Consider
While ROBS is a viable method for funding your startup, it’s not the only option. Here are a few alternatives:
A word on taking money from retirement accounts:
You may take a taxable distribution from your individual retirement account (“IRA”) at any time. However, taxes will be due, and an early distribution penalty will apply if you are younger than 59 ½. Roth IRA distributions are tax- and penalty-free at that age. Before that, only contributions made to the Roth can be withdrawn without consequences.
Unlike an IRA, a 401(k) qualified plan or other pension plan must satisfy certain “triggering rules” before the funds are accessible. Essentially, one must reach the age of 59 ½, separate from their job, or suffer a hardship before gaining access to the plan funds for distribution purposes.
The downside of taking a distribution from your retirement plan is you are taking out funds that are growing in a tax-advantaged way. Moreover, if you are younger than 59 ½, you will be hit with that 10% early withdrawal penalty.
1. 401(k) Loans
Some employer-sponsored 401(k) plans allow you to borrow money against your account balance. If allowable, you would be able to borrow the lesser of $50,000 or 50% of your account value. The proceeds of the loan can be used for any purpose, including starting a new business. You will generally have up to five years to repay the loan. Payments must be made at least quarterly, at an interest rate of at least prime, which stands at 7.50% as of this writing.
The advantage of using the loan option to fund a business is you can get tax- and penalty-free use of your 401(k) savings. Further, you avoid paying a higher rate with an outside lender, and all interest is paid back to the plan.
2. IRA Loans
This is kind of a misnomer because you can't borrow money or take a loan from an IRA. That said, there are some ways to get money out of your traditional IRA or Roth IRA in a pinch. If you can replace the money in 60 days or less, then a 60-day rollover might be the ticket for you. IRS rules allow you to roll money from one IRA to another one or back into the same IRA, as long as you do it within 60 days. During that time, you can do what you like with the money. It’s a somewhat complicated and risky maneuver, but as long as you follow the rules, you can get money out of your IRA without owing penalties or taxes.
3. Self-Directed IRAs
Investing through a self-directed IRA allows for greater flexibility and can enable you to invest in various ventures, including startups. You cannot invest in a business in which you already have an ownership interest. You also cannot buy a business from yourself or other disqualified individuals in your self-directed retirement plan, but all other businesses are fair game. However, there are strict guidelines that you need to follow. An investor opens a self-directed IRA or other account with a self-directed custodian. The investor directs the custodian to invest in the business. The assets are held in the name of the self-directed account. The drawback is that the IRS rules prohibit any direct or indirect benefit between a plan and a disqualified person. Disqualified persons include you, your spouse, lineal family and certain financial or business relationships.
Legal Considerations
Before proceeding, it's crucial to consult with a legal expert or a financial advisor, especially one familiar with Pennsylvania business laws and IRS regulations. The consequences of mishandling your retirement funds can be severe, including the potential reclassification of your retirement account with significant tax penalties.
Using your retirement account to fund a startup can be a double-edged sword. While options like ROBS present an innovative solution to access capital, they come with risks and obligations. Carefully consider your financial situation, seek professional advice, and weigh the pros and cons before making any decisions. Remember, your retirement is important, and protecting those savings should always be a priority.