How to Use a 401K to Fund a Start Up Business

If your dreams of starting a business are bigger than your startup budget, you may be glancing at your 401(k) retirement nest egg as potential seed money. You’ve resisted the impulse to withdraw your retirement funds until now, but you know it could make your business dream a reality. If you're ready to take the plunge, make sure you have all your legal ducks in a row before you withdraw money from a 401(k) for a business startup.

Risk Vs. Reward

After diligently saving money in a 401(k) account for your retirement years, the thought of losing it can be daunting. As long as your nest egg is safely tucked in your 401(k), your comfort level of enjoying the funds in retirement is likely pretty high. But if you use this money for a startup, you may want to brace yourself for a sobering reality check.

According to the U.S. Bureau of Labor Statistics, 20 percent of new businesses fail in their first year, and 50 percent fail in their fifth year. Staring in the face of a 50-50 proposition that your startup will fail after five years may send you looking for other funding options so you can preserve your 401(k) nest egg.

Other Startup Funding Options

Because of the high failure rate of business startups, the Wall Street Journal points readers away from using retirement money, such as a 401(k) to fund a business, if other funding is available. If possible, use nonretirement assets for your startup and preserve your nest egg. For example, after setting aside a six-month emergency savings fund, use taxable savings or brokerage accounts as seed money for your startup. Other non-401(k) options include home-equity credit and loans.

401(k) Business Financing

If you decide to withdraw money from a 401(k) for a business startup, you can use a specific type of funding called 401(k) business financing. This allows you to use the money from your 401(k) account without having to pay income tax on the withdrawal, called a distribution, or without getting a traditional bank loan. This 401(k) business financing arrangement is called Rollovers for Business Startups – ROBS, for short.

What Is ROBS?

According to the Internal Revenue Service, ROBS – Rollovers for Business Startups – is an arrangement that allows prospective business owners to use retirement monies to fund their startup businesses. In a nutshell, an individual rolls over retirement funds to a ROBS plan and uses these rollover funds to buy stock in his own startup. If the transaction is done correctly, the rollover is tax-free, and the new business owner has access to 100 percent of the rollover funds. If the transaction is done incorrectly, however, the new business owner may face taxes and penalties.

ROBS is not a loan that you have to repay monthly after you roll over a 401(k) to start a business, and it's not even considered a withdrawal from your 401(k). Even if your business fails, you do not have to repay any of these rollover 401(k) funds.

401(k) Business Startup Funding Benefits

By eliminating any monthly repayment requirement, as you would have with a business loan, you'll start out with a clean, debt-free slate as new business owners. And it’s possible that your credit isn’t quite up to par, which means that securing a business loan may not even be an option. Regardless of your credit, you can tap into your eligible 401(k) funds. And without any tax liability, early withdrawal fee or penalty payment, 100 percent of your rollover 401(k) startup funds can be channeled directly toward your business costs.

Essential 401(k) Startup Steps

You’ll have to follow an exact protocol to take advantage of the ROBS plan and use 401(k) funds for your business startup, tax- and penalty-free. First, you’ll need to create a C corporation and set up a retirement plan for it. After these two fundamentals are in place, you’ll roll over your existing 401(k) funds to the new retirement plan you’ve just set up for your new company. With these newly rolled-over 401(k) funds, you’ll then purchase stock in your own new company to capitalize its financial needs.

Forming a C Corporation

Owners of C-corps are taxed separately from the corporation itself, which limits the liability of individuals. The corporation’s debt is not passed to its principals and cannot become personal debt obligations. Because a C-corp is the only business entity that can legally sell shares to a retirement account, it’s the only business setup that’s compatible with the ROBS plan. You cannot pair a sole proprietorship, limited liability company or S corporation with a ROBS plan.

Because of the importance of dotting all your i's and crossing all your t's with a ROBS plan structure, you may want to work with a business attorney to set up your C-corp.

Establishing a Retirement Plan

Working with your business attorney, set up a retirement plan for your new C-corp. You don’t have to roll over your 401(k) funds to another 401(k), although that’s one of the retirement plan rollover options. You can also use a profit-sharing plan, a defined benefits plan, a defined contribution plan or even a combination of these plans. Certain business-specific factors determine which plan is best for your new startup, such as the number of employees and the number of highly paid employees.

You’ll also need to appoint a custodian to manage the retirement plan you choose, which is another decision your attorney can help you facilitate.

Rolling Over 401(k) Funds

When your C-corp is set up, and you’ve established its new retirement plan, it’s time to roll over your personal 401(k) funds to the new C-corp startup business. The custodian who currently holds your 401(k) funds will transfer funds to the new custodian of your C-corp's retirement plan. Although this typically is a seamless transaction, call on your attorney if there are any bumps in the road with this process.

Purchasing Stock With 401(k) Funds

After a successful 401(k) funds transfer to your new corporation, you have the green light to invest this money in your company’s stock. By doing this, you’re essentially buying shares of your own business to fund its operation.

According to Forbes, the IRS has upheld the legality of this procedure, even though it’s controversial and subject to IRS audit. The ROBS plan capitalizes on a certain exception in the tax code that allows someone to use rollover 401(k) funds for buying stock in a C-corp, after which the C-corp can use the funds from the sale of stock to purchase business assets.

The IRS acknowledges that although ROBS plans do not constitute abusive tax avoidance transactions, they may be questionable transactions because of how they benefit a single individual. Because of this eyebrow-raising caveat, make sure you keep the details and transactions of your new business startup in alignment with IRS regulations when structuring your ROBs plan.

Capitalizing Your New Startup

With your seed money now in hand because of your 401(k) business financing, you’re ready to capitalize your new startup. You can use funds for working capital, business acquisition, paying employees or even as a down payment for additional financing – the IRS sets no limits on the use of ROBS funds, with the exception that they cannot be used for your personal expenses that only benefit you.

ROBS Can Fund Franchises

Senior tax analyst Dick O'Donnell notes that many people think 401(k) business financing is particularly suited to funding franchise startups. Franchises are typically associated with successful businesses that have proven track records, while a small mom-and-pop startup business leans more toward speculation and sentiment than concrete statistics.

Fast Process for Receiving Funds

Once the ball is rolling on your ROBS plan, it's generally a short time frame before receiving your startup funds. You may have funds in hand in less than a month, sometimes as soon as two weeks. If you're negotiating a startup business deal, such as buying a franchise, or wanting to purchase inventory during a seasonal markdown, a fast turnaround time can make all the difference in closing important deals.

Choosing a Skilled ROBS Provider

ROBS providers are invaluable resources. If you’re considering 401(k) business financing, a ROBS provider will not only help walk you through the setup phase, but the provider will also provide post-setup support. Because of the intricacies of this type of business financing, the IRS requires ongoing compliance, which includes monthly and annual reporting. Keeping up with these legal regulations is not for the inexperienced business person.

Consider these criteria when evaluating a potential ROBS provider:

• Setup fee. Each provider will quote you a setup fee for the initial cost of setting up your ROBS plan.
• Maintenance fees. These fees ensure that your ROBS plan maintains its compliance with IRS regulations, including any changes in tax legislation.
• Ongoing support. Look for a hands-on provider who stays on top of filing the proper paperwork on a timely basis and efficiently maintains your plan.
• Communication. Find a provider who will keep you in the loop by maintaining communication and one who is easy to contact when you have questions.

Some notable ROBS providers for 2019 are Guidant, FranFund, MySolo401k, Benetrends, Pango Financial, Catchfire Funding and Business Funding Trust.

IRS Favorable Determination Letter

Providers and promoters of ROBS court prospective business owners, sometimes by requesting a Favorable Determination Letter from the IRS. The FDL is a way that providers try to assure a client that the IRS approves of the client’s ROBS plan. The IRS typically issues a letter, but it’s based on acceptable compliance of the client’s ROBS plan. This letter is neither a blanket approval of the plan nor legal protection if the plan is incorrectly set up or administered.

ROBS IRS Memorandum

As 401(k) financing plans began to gain momentum in the early 2000s, it didn’t take too long before the IRS began scrutinizing them for possible abuse. In 2008, the Tax Exempt and Government Entities Division of the IRS published the administrative guidelines for Rollovers for Business Startups, which became known as ROBS. These guidelines are still effective today, in what is known as the ROBS Memorandum. Your attorney, tax professional and ROBS provider should be familiar with all these guidelines to set up your ROBS plan legally.