Entrepreneurs who don’t want to take a traditional bank loan may want to consider using their retirement money to start a business. However, entrepreneurs who choose this route need to be careful to avoid putting their retirement savings at risk. Below are some tips for using retirement money to start a business to help guide you.
Here are the top 17 expert tips for using retirement money for your business:
1. Work With a ROBS Expert
Jeffrey A. Schneider, EA, CTRS, ACT-E, SFS Tax Problem Solutions
Rollover for Business Startups (ROBS) is very popular for buying an existing business or franchise. This is where you set up a corporation (C corporations only). You set up a 401(k) plan within the business. You rollover funds from an existing retirement plan (trustee to trustee) and use that money to start your business. The caveat here is that the plan owns the business. You cannot take it from a current employer and you have to be a legitimate employee of the new business and get paid out of operations. To set this up, you have to work with an expert that knows the ins and outs of the process. Be prepared to pay for fees, as it’s not like a self-directed IRA.
Here’s our guide on the best ROBS providers for 2019.
2. Look for Alternative Financing Options First
April Lewis-Parks, Director of Education, Consolidated Credit
Using your retirement money to fund a business is a risky proposition that could cause long-term financial instability. Look at the alternative options first, like savings, brokerage accounts, bank loans, and even borrowing from family members who may want to support your business and invest in you.
If you’re under 59.5 years old and you pull the money out of your retirement account incorrectly, you’ll have to pay taxes on that money and you’ll be hit with an early withdrawal penalty that can add up to thousands of dollars lost. If you are still employed, you might want to consider a loan from your 401(k), but the loan usually must be repaid before you terminate employment. If you have a Roth IRA, you can take tax-free and penalty-free withdrawals of all contributions that are at least five years old, but you can’t replace the money after it’s withdrawn.
Using your retirement money to start or buy a business is an important decision that needs to be carefully reviewed with a financial adviser and tax professional.
Read our article about startup business loans if you want to learn more.
3. Consider Using HELOC Instead
Robert R. Johnson, PhD, CFA, CAIA, Professor of Finance – Heider College of Business, Creighton University
Utilizing retirement funds to start a business is simply a terrible idea. No one thinks that their business is going to fail, but the vast majority do so. People who get to retirement age and have not saved enough money for retirement either continue to work or accept a lower lifestyle in retirement.
Instead of utilizing retirement funds in order to start a business, one should look for other means of financing. If one has home equity, a Home Equity Line of Credit (HELOC) is certainly preferable to raiding retirement funds. One should also consider a bank loan. If lenders are unwilling to lend money after an analysis of your business plan, that might be a good indication that the plan could be flawed.
4. Have a Solid Business Plan
Matthew Gillman, CEO, SMB Compass
Starting a business is a big task. Regardless of where the money comes from, make sure to have a solid business plan. When using hard-earned money that you’ve saved over your career, it’s more essential than ever to do market research and perfect your business plan. Speak with other business owners and industry professionals to test your plan. Does your product or service offering have buyers? What does your competition look like? Can you line up customers before you invest your money? You won’t always get all the answers or the help you need with your business plan, but knowledge is power, and the more of it that you have, the higher your probability of success will be.
5. Be Willing to Take Risks
Dustin Ray, Business Development, Incfile
Whether you use a Rollover for Business Startups (ROBS) or take a retirement plan loan, it’s important to be aware of the risks involved. The biggest risk with either financing option is the possibility of losing your savings and not having enough money to retire. When selecting a financing option, which you choose to go with will most likely come down to the pros and cons associated with each, which works the best for you, your accounts, and your business needs.
If you are not sure which is the right fit for you, thoroughly investigate each with the help of a professional. Regardless of which funding option you choose, it’s important to avoid any mistakes along the way. You may face increased scrutiny from the IRS after completing a ROBS or loan for your new business, and any mistakes made during the filing process could result in IRS penalties during an audit. No matter what choice you make, or how well you prepare, using your retirement for business development is for people who are willing to take a risk on themselves.
6. Understand the Requirements of ROBS
Mike Savage, CPA, CEO, 1-800Accountant
As far as using a 401(k) plan to start a business, the ROBS financing route is one you can take. You must, at least, invest $50,000 and also use a pension consulting firm to assist you for compliance responsibilities. You set up a C corporation, and the 401(k) funds are used to purchase the corporate stock. The 401(k) plan is the actual corporate shareholder.
There are annual 5500 filings due, so you have to maintain the consulting firm, also referred to as a ROBS provider. Be aware there are costs to this method. You should not attempt this without engaging a consulting firm to assist them. Also, you have to set up a C corporation to do this. You only do this type of option if you are planning to work on a full-time basis, have enough assets, and identify a good provider. Using an IRA will also qualify.
7. Only Use a Portion of Your Retirement
Stewart J. Guss, Founder, Stewart J. Guss, Attorney At Law
It is perfectly okay to explore new horizons and invest in them, but prepare for the worst case scenario. Make sure you are completely cognizant and realistic about the risks and possibility of failure. Make sure that you do not invest more than you can afford to lose and still comfortably retire, no matter how excited you are about the business opportunity. To this end, it makes sense to run your plans by a financial adviser or other trusted resource before you “pull the trigger” on your plan.
8. Know Your Available Options
Adam Bergman, President, IRA Financial Group
You can establish a 401(k) plan with a loan option and use that to borrow up to $50,000 to finance the business. You pay back the interest on the loan to the plan without an early withdrawal penalty, and this will not be taxed. Another option is the Rollover for Business Startups (ROBS) solution, which takes advantage of an exception in the tax code under IRC 4975(d)(13) that allows a 401(k) plan to purchase stock in the adopting corporate employer (qualifying employer securities). The ROBS plan allows you to use your retirement funds to buy a business without taking a taxable distribution.
Find out how to use a 401(k) to start a business here.
9. Set Up a ROBS
Richard Best, Finance Writer, DontPayFull
To avoid taxes and penalties on a big withdrawal from a retirement plan, an increasing number of advisers are recommending the use of Rollovers as Business Startups (ROBS). ROBS allows you to use your retirement funds to start or buy a business without paying taxes or early withdrawal penalties. Make sure to speak with a ROBS expert to understand the process and the requirements.
For more information about ROBS, read our article here.
10. Keep Your Books Clean if You Decide to Use ROBS
Kenneth Ameduri, Co-founder & Chief Editor, Crush The Street
As far as ROBS go, there are some double taxation issues that could be less favorable depending on your marginal tax rate. Also, the government is aware that many people have used the ROBS tax exemption and that not everyone has used it for 100% straightforward reasons, and they are therefore scrutinizing it more. So if you do decide to do this, make sure your books are in line and everything is on the up and up, because there is higher scrutiny for people who opt for ROBS.
11. Get a Loan From the Owner of a Self-directed Retirement Plan
Jaime Raskulinecz, CEO, Next Generation Services
An alternative is for the business owner to arrange a loan or procure funding from the owner of a self-directed retirement plan. Self-directed IRAs may include secured or unsecured loans, private equity, and private placements among the alternative assets these plans allow. The terms are worked out between both parties and the plan administrator executes the transaction. This avoids the potential for self-dealing and what the IRS would consider a prohibited transaction. The retirement plan earns tax-advantaged income when the loan is repaid with interest, or dividends are paid.
12. Know the Risks Associated With ROBS
Paul Kassabian, Legal Product Counsel, LegalZoom
Before you drain your retirement savings, make sure you think through the risks. Rollover as Business Startups (ROBS) is one common way to transfer personal retirement funds to your business without having to pay early withdrawal penalties or income taxes, but the process is complex. Generally, the maximum loan amount from a retirement plan is $50,000. Cashing out your 401(k) before the age of 59.5 will mean tax and penalty obligations, so consider it very carefully before taking that route. It’s a good idea to consult with a tax adviser who can help you review your options and decide on the best way to use your retirement funds for your business.
13. Keep Business Expenses to a Minimum
Daniel L. Grote, CFP, BFA, Certified Financial Planner, Latitude Financial Group, LLC
Just as you must do with your time, you must consider whether or not each expenditure is putting your hard-earned dollars to their highest and best use. Understand that tomorrow, there will be new opportunities to spend money in your business, and the resources spent today will not be available tomorrow. Proceed with expenditures intelligently and boldly, especially if you are using your retirement money for this.
14. Only Use a Part of Your Savings
William Seavey, Retirement Consultant, Retirement Possibilities
No one should endanger their nest egg unless they simply must gamble on a business in order to ensure a retirement income. You can set a small portion, around 10%, of your liquid or liquidatable assets to a business possibility, and then reassess later how effective it is. If the business idea continues to have potential for growth, or starting to turn a profit, you can apportion more.
15. Test Proof of Concept First Before Jumping In
Tom Blake, Owner, This Online World
While the idea of starting your own business and becoming an entrepreneur might sound alluring, using your retirement money to fund a new venture needs to be done with the utmost care. Your retirement savings is your nest egg, and any use of those funds has to be done in a calculated way that mitigates as much risk as possible. If you are considering starting a new business, think of ways you can test proof of concept with less capital to gauge the market and your consumers before going all-in.
According to the Wall Street Journal, most advisers are likely to charge high fees to help set up a plan. This makes this strategy a good option only if you are investing a big chunk of your retirement money (at least $50,000) in a business that is sure to succeed. If you are not sure where this business may lead you, it’s best to consider other financing options that don’t involve your retirement assets.
Using your retirement funds to start a business is considered a gray area. Good Financial Cents says that the IRS looks at this transaction carefully, and there are compliance issues that you need to adhere to. If the IRS were to decide that what you did was in the wrong, you could end up being billed up to 100% in tax penalties.
It’s possible to use your retirement money to start a business. However, this can be very risky if you aren’t careful. It’s important to know your options and to do your research before you decide to take this path. Also, make sure to use the above tips from the experts to help minimize your risks and increase your chances of success.