Securing financing is one of the biggest hurdles future entrepreneurs face. As any fiscally responsible individual, you’ve moved a portion of your earnings into a 401(k) account. Over time, the account grew, the amount providing a certain level of certainty.
Traditionally, a 401(k) is put away for retirement. Funds accumulated throughout years of work are taken out after retirement to pay for future expenses; however, other options exist.
You’ve found yourself with a business opportunity too hard to pass up, but all your funds are tied up with other obligations. A well-maintained 401(k) - money that is yours - is a great solution in many instances.
Read on for more information on how to make your 401(k) work for you now.
Three 401(k) Options to Fund Your Business
As the title would suggest, there are three options an entrepreneur can use to fund their business: ROBS, 401(k) loan, and 401(k) withdrawal. We’ll take a closer look at each of these options to help you make the best decision.
Rollover for Business Startup (ROBS)
The ROBS or Rollover for Business Startup option is the one most often used and the one you’ll most likely focus on when it comes to using your 401(k) funds. As a future business owner, this option will allow you to pull out your retirement funds in a tax-advantaged way.
The ROBS process takes an existing retirement plan and “rolls” the funds into the new company in exchange for stock - stock that you issue to yourself. This rollover process is a tax-free way to invest in a business.
Not especially complicated in any way, ROBS requires you to follow a few procedures defined by the IRS. The procedures avoid tax complications and other potential compliance issues.
If you choose to have someone follow the steps for you, there are providers who will do it for you at the rate of about $4,000. These providers or accounts will also help with other services, such as setting up a C Corporation and issuing Qualified Employer Securities (QES) - a somewhat involved part of the ROBS process. Only once these are set up can your retirement plan purchase stock from your newly formed C Corporation.
To boil this down further, the ROBS process has five steps to complete:
To begin, you need to set up a C Corporation
Start up qualified retirement accounts for all employees within the C Corporation
Roll over existing retirement funds such as a 401(k) into the C Corporation plan
Use the retirement plan to purchase stock within the company - something only possible with a C Corporation
A business receives proceeds from the stock sale, which makes them available for business use
ROBS Advantages
The most noted advantage is that ROBS is tax and penalty-free. Those looking to purchase or start their own business can use a 401(k) to their advantage while minimizing purchase and transfer costs.
Using ROBS means becoming an employee of your new business, which affords your retirement plan the same protection as any other under the Employee Retirement Income Security Act (ERISA). This law serves to guide adherence to many retirement plans - 401(k) among them - and is a companion during the ROBS setup process.
Another advantage is the simplicity of ROBS. In all honesty, the paperwork required to complete the process will take longer than the acceptance and clearance, with most taking no longer than a couple of weeks. This time frame is rather short in relation to other options, such as SBA loans or private funding.
Since ROBS is only available under a C Corporation, it’s important to review some of the advantages of that type of corporation.
First, profits from C Corporations are not taxed and do not affect an individual’s tax bracket. Gains made through a C Corporation are taxed at the corporate rate of 21%, a much lower rate than the individual 37%.
C Corps comes with other advantages, as well. These types of corporations can deduct health insurance costs paid on behalf of employees, pay salaries such that they deplete taxable profits, and have the flexibility of choosing when to file fiscal year reports.
ROBS Disadvantages
Before choosing the ROBS process, it’s important to also understand the potential disadvantages of this solution.
First, though simple in the grand scheme of things, ROBS requires paperwork, which some might find bothersome, others downright confusing. Of course, the IRS doesn’t take kindly to those who make a mess of their 401(k), so this is an important step.
Businesses are started with the intent of turning a profit - after all, what else would be the biggest motivator? But the harsh reality is that not all small businesses survive. Even the IRS warns on its website detailing the “Rollovers as Business Start Up Compliance Project” that many ROBS failed or were sold before they became a failure. Their warning is not only regarding failing businesses but the loss of the full retirement plan, something that may have taken years to build.
Another disadvantage many find bothersome is that the ROBS structure is more complex than a simple loan on top of putting 401(k) savings at risk. Due diligence and a solid plan are the keys to starting the venture on the right footing.
These disadvantages should have you asking certain questions, such as whether your personal risk tolerance aligns with running a small business.
401(k) Loan
Those who decide that the ROBS direction is not the right one can take out a 401(k) to fund the business. The advantage of this type of loan, against all others, is that you are lending from yourself and putting up your own collateral. Don’t hesitate to reach out to the plan administrator for more information.
Compared to ROBS, a 401(k) loan is a simpler process. Just like ROBS, there are no IRS penalties for using the funds. Any interest on the loan is repaid back to the lender - in this case, you. The interest goes back into your account, growing the amount while you repay the original loan. The interest itself already makes a 401(k) loan better than a private loan through an outside bank.
A 401(k) loan allows you to take out up to $50,000 or 50% of your savings within 12 months. The loan itself is amortized over five years and requires strict repayments to ensure you don’t fall behind and lower your credit score. Keep in mind the retirement plan administrator is the one to set the interest rate, though they are comparable to other five-year business loans.
In the event the loan defaults, the IRS will tax the defaulted amount at a rate of 10% for those under 59.5 years old. Do what you can to pay back the funds as soon as possible to avoid these types of fines.
Of course, taking out a loan also lowers the total amount invested. Should those investments take off, you could miss out on substantial gains, so discussing all of this information with the 401(k) provider before moving forward is important.
Although a 401(k) loan doesn’t have the same advantages, it’s a great alternative to using ROBS, unlike the 401(k) early withdrawal mentioned below.
401(k) Early Withdrawal
To help cover an emergency situation, taking out a 401(k) withdrawal is a worthwhile option. This route is attached to some hefty penalties and will have a noticeable impact on the overall health of the retirement account.
Of course, certain situations would warrant this route, such as a medical emergency, a broken car, avoiding repossession, and many others. There is no penalty for individuals who lose their jobs and are over 55 who could use the immediate funds, making this a solid option; however, that is not the case for many.
Most recently, the CARES Act favors withdrawals up to $100,000 for coronavirus-related expenses. Only qualified individuals can make use of funds under this section of the Act, restricting the use.
Considering all the penalties and the income taxes due at the time of the withdrawal makes this option the least favorable of the three. There aren’t many benefits associated with this funding structure, making individuals favor the loan or ROBS for business investment.
What Option to Choose?
The decision on which option to choose is up to you. Based on everything reviewed so far, ROBS is by far the most favorable option. If you’re not afraid of a little paperwork or are willing to pay someone to do it, ROBS is the solution to funding woes.
A 401(k) loan is a decent alternative to ROBS, but it’s best to leave 401(k) withdrawal alone. The penalties levied against early withdrawals outweigh any marginal benefits the option would have. Instead, make the 401(k) work to your advantage as you work to pay yourself back.
Once you go down the path of starting or purchasing a business to make a potential profit, such as those you could find with Smobi, funding is the next step in the process. Make your 401(k) retirement plan work to your advantage as you build the next stage of your life. Read our guide on other common ways to finance your next business acquisition to explore your financial options.