Funding your small business with your 401(k) fund is a great way to get your startup off the ground without going into debt. After all, the money’s already yours—you spent years accumulating those funds with your hard work. Now it’s time for all that hard work to pay off on your terms!
Some entrepreneurs choose to cash out or take a loan against their 401(k) when they’re ready to launch their businesses. While withdrawing those funds is an option, it isn’t always the most cost-effective. A large portion of your retirement funds will need to be used to pay the withdrawal penalties and additional taxes, so you won’t be able to use all your hard-earned money for your business.
Luckily, there are other ways to utilize your retirement funds to invest in your small business. A Rollover for Business Startups, or ROBS, allows you to access your own retirement accounts tax- and penalty-free to fund a business, purchase another company, or invest in a franchise. Are you ready to prepare your 401(k) for business financing? Read on for a beginner’s guide to ROBS and what you need to get started.
Is a ROBS Right for You?
ROBS is a great way to obtain cash if you don’t want to borrow money from a lender, and it also allows you to save on loan fees and interest charges that would normally be paid on a loan.
However, it isn’t without risk. If your business fails, you could lose the entire balance of the retirement accounts that were used.
A 401(k) rollover for business startup could be the solution for you if:
- You want to avoid borrowing money to improve your cash flow because you will not have the added expense of a loan payment. Also, you may find it difficult to secure a loan as a startup.
- You have an eligible retirement account such as a 401(k), 403(b) or traditional individual retirement account (IRA).
- You must be an active employee in your company.
- You have a minimum of $25,000 vested in your 401(k).
Starting the Rollover Process
If your 401(k) qualifies for rollover business financing, here are the steps you will take to set it up.
Form a C Corporation
To roll your existing 401(k) funds into a new retirement fund in your business’s name, your business must be structured as a C corporation. It’s the only business format that can issue the type of stock that will allow you access to your retirement funds.
Are you already incorporated as an LLC or another entity? You’ll have to convert to a C Corporation in order to comply with ROBS regulations.
Start a New 401(k) Plan
Now that your business is set up as a C corp, open a brand-new 401(k) retirement plan in your new business’s name. Moving retirement money from one 401(k) directly into another is how you will avoid additional taxes and withdrawal penalties.
Roll the Funds Over
With your administrator’s help, roll over the money from your 401(k) into the new corporate plan you just set up. Here your C corp received the cash from the retirement plan.
Issue Stock in Your Business
In exchange for this cash, the corporation issues stock to the plan. This process is similar to when you decide to purchase stock from a publicly traded company. By buying the publicly traded stock, you give the company cash that it can then use for its business operations.
Start Operating Your Business
Once your new C corporation’s retirement plan purchases stock in your business, the funds will then be made available for use. Funds can be used for many business-related activities, including equipment, payroll, and other operational expenses.
Risks and Rewards of a ROBS
Before you start the rollover process with your 401(k) retirement account, think about your vision for your business. While using your retirement funds to start your business sounds like a dream come true, be wary of the risks of using your nest egg this way.
Potential Risks
Your 401(k) account holds your retirement savings. Are you sure your business plan is salient enough to survive the ups and downs of ownership?
If your business idea is not tried and tested, you’re gambling with your nest egg. For this reason, some financial advisors believe that using a ROBS to invest in an existing franchise is smarter than starting an untested business from scratch.
In addition, if you’re using a ROBS to fund your business, you must be an active full-time employee of your company. Rolling over your retirement account and then becoming an absentee owner can set off alarm bells at the IRS.
When you commit to full-time employment at your new business, be wary of setting your own salary using your retirement fund’s proceeds. This practice can quickly bleed your 401(k) investment dry—especially if you pay yourself a large salary.
Potential Rewards
While there is a wide variety of potential complications to look out for when using a ROBS, there are also plenty of potential upsides to rolling over your 401(k).
When you start your new business using a ROBS, you start your business’s financial history free of debt. More of your monthly budget can go towards growing your business instead of making loan repayments.
Funding your business with a ROBS also has no impact on your personal credit. Remember when you structured your company as a C corporation? That designation keeps your business and personal finances separate.
Using ROBS to fund a new or existing business is a popular choice for many entrepreneurs. If you meet the eligibility requirements to roll over your retirement account, start preparing your 401(k) for business financing today!
For more information about small business funding options, head over to the funding solutions tool at Pango Financial.
