Using Retirement Funds to Buy a Business
If you’re considering entrepreneurship as a next step in your career journey, or if you’re ready to leave your corporate gig but don’t quite have the savings to start a new business, there's some good news. You might just have the funds you need to finance a new business venture or buy an existing business without going into debt.
Look no further than your retirement funds.
Yes, leveraging the funds in your 401(k) can help cover the start-up costs of a new company.
But before you cash yours out, let’s look into why and how retirement funds can be used to buy a business, as well as the pros and cons.
Why Use Retirement Funds to Finance a Business?
There are many reasons to use retirement funds to finance a business venture, including:
- Access to capital: Retirement funds can provide a significant amount of capital without taking out loans or finding investors.
- Lower debt burden: You can avoid the high-interest rates and strict repayment terms of business loans.
- Tax benefits: Depending on the investment structure and the type of retirement account, there can be tax advantages to using retirement funds.
Although using your retirement fund can be an excellent opportunity, there’s more to it than simply withdrawing your savings and investing them elsewhere.
The strategy behind using retirement funds to finance a business is called “Rollovers for Business Startups,” or ROBS for short.
What Are Rollovers for Business Startups?
ROBS is a business financing strategy where you roll your 401(k) out of a financial institution and into your business penalty-free if it’s an early withdrawal with no immediate tax penalties. It’s different from a withdrawal or loan against your retirement account and has some limitations.
With careful planning, ROBS is a viable alternative to a small business loan. If you can start or invest in a business debt-free and with cash flow to boot, why not, right?
How ROBS Works
If set up incorrectly, using ROBS to start a new business or purchase an existing one can have serious tax implications with the IRA.
Here’s how it works.
Step 1: Set Up a C-Corporation
The first step in a ROBS plan involves setting up a C-corporation because only C-corps can issue qualifying employer securities—a requirement for the ROBS arrangement.
Step 2: Create a New Retirement Plan
Your newly formed C-corporation now needs to set up a new 401(k) retirement plan with the option of investing in employer stock.
Step 3: Roll Over Existing Retirement Funds
Next, you’ll roll your existing retirement funds into the new corporation's 401(k) plan. Because this rollover is transferred directly between retirement accounts, it’s not considered a taxable distribution.
Step 4: Purchase Company Stock
The new 401(k) plan uses the rolled-over funds to purchase stock in the C-corporation, and the retirement funds are now invested in the business.
What Are the Pros and Cons of Using ROBS?
Unlike traditional financing options, ROBS is not a small business loan, so there's no debt or repayment obligation.
However, the growth of your retirement savings is now directly tied to the business's success.
The pros of ROBS:
- No debt or interest payments
- Access to significant capital (if you have substantial funds in your retirement account)
- No early withdrawal penalties or tax penalties
- Potential for high returns if your business does well
- You don’t have to give up equity to investors
- Investing in your own business can be fulfilling and motivating
- Access to startup money if you have a poor credit score and don’t qualify for a traditional small business loan
- It can open up opportunities for additional capital, like a Small Business Administration (SBA) loan
The cons of ROBS:
- If the business fails, you might lose your retirement savings
- ROBS is complex and requires strict adherence to IRS and Department of Labor rules
- Ongoing costs for administering the plan and the C-corporation
- ROBS requires setting up a C-corporation, which may not be the ideal structure for your business
- Investing a large portion of your retirement funds in a single business reduces the diversification of retirement assets
- Initial setup can be costly
What Are The Risks of Using Retirement Funds?
Using retirement funds to buy a business can be risky. As you’ve learned, there are several credible arguments to support both sides of the coin (pun intended).
But the most significant danger of using your 401(k) is losing your retirement savings. If the business goes bust, the money you've saved for your future can quickly disappear.
This type of investment also goes against the idea of spreading your risk. Putting a big chunk (or all) of your existing retirement plan into one business means your financial future could be unstable if it doesn't do well.
Enlist the Help of a Financial Advisor
If you dream of becoming a business owner, working with a professional experienced in ROBS arrangements to set up and maintain the plan is highly recommended.
Although it’s an excellent opportunity to buy a business without incurring debt, ROBS is a complex process with strict IRA and IRS regulatory requirements. If you miss a small detail, it could be costly.
The involvement of experts, including CPAs, lawyers, and business brokers, can facilitate a more streamlined acquisition process. Visit BizBuySell’s Business Broker Directory to connect with a buy-side business broker and read up on the process of how to buy a business in our Buyer Learning Center.