×

Funding a start-up from your 401(k) can be risky business

Aspiring entrepreneurs can use an arrangement called a "rollover as a business start-up," or ROBS, to fund their start-up businesses from their retirement accounts.

Depending on the entrepreneur's personal, organizational and financial profile, it could be a great idea — or a terrible one.

Thomas Barwick | Getty Images

The following is a simplified process for creating a ROBS, according to Guidant Financial, a company that provides ROBS financing services.

  • A private corporation is created for the client, who then rolls the existing retirement funds into a new 401(k) plan.
  • The plan makes an investment into the newly formed corporation.
  • The corporation uses the investment proceeds to acquire a franchise or other small business, and the 401(k) becomes the shareholder.

Is it too risky?

"The opportunity for loss exists no matter how you fund your business," said David Nilssen, Guidant CEO. "However, when using a ROBS, clients are not risking credit, personal cash or their homes as collateral — they don't have debt when they start out their businesses."

Most of Guidant's customers use less than 75 percent of their retirement assets for the ROBS, rolling over an average of $190,000. Nilssen points out that they still have their 401(k) plans, which are now within their new businesses.

Most of the start-ups seem to have stayed in business, he said. "After four years, 75 percent of customers were still subscribing to Guidant's 401(k) record-keeping services, and other customers may still be in business but using services from another provider."

"There are so many prohibited transactions, it's like going through a minefield. You're going into this knowing that the IRS will be scrutinizing you." -Jeremy Portnoff, certified financial planner, Portnoff Financial

Potential minefield

"The concept is reasonable as long as you follow the rules," said Jeremy Portnoff, a certified financial planner with Portnoff Financial. "But it's difficult to follow the rules as presented by the IRS."

He explained, "There are so many prohibited transactions, it's like going through a minefield. You're going into this knowing that the IRS will be scrutinizing you."

One prohibited transaction can "blow up" — meaning, disqualify — the new plan, leading to taxable income, early withdrawal penalties, accuracy-related penalties and more, Portnoff said.

Examples of prohibited transactions, according to an FPA Journal article, include:

  • Failure to notify employees of the existence of the plan and their rights to participate in it and purchase available company stock.
  • Plan assets not valued, or valued with a threadbare appraisal.
  • Non-filed annual reports.
  • Clients' use of plan assets for non-business purposes.

One "pro" to any given ROBS, said Mark LaSpisa, CFP and president and managing advisor of Vermillion Financial Advisors, is that "if it works — if you don't accidentally blow it up — you can supercharge your IRA if you're successful."

"But the number one 'con' is the danger of triggering prohibited transactions," he added. "Once it's all set up and the initial advisors go away, it leaves the responsibility to the client to stay within the IRS regulations.

"If this is your only resource, you'd better have a process in place," LaSpisa said. "You may be starting with no debt, but costs associated with plan administration can add up significantly."

LaSpisa believes that most entrepreneurs are not detail-oriented enough to maintain compliance on their own. He worries about their overconfidence.

Your Wealth: Weekly advice on managing your money

Sign up to get Your Wealth

Please enter a valid email address
Get this delivered to your inbox, and more info about about our products and service. Privacy Policy.

"They have visions," he said. "They have very little fear. With this funding possibility, "you're just fueling their fire."

LaSpisa added, "But if they have an on-staff accountant who understands prohibited transactions and what can or cannot be paid, I have no problem with it."

Second thoughts

Although he did not use a ROBS account, Daniel Sheehan, CFP and owner of Sheehan Life Planning, used his individual retirement account to fund a start-up company, which he sold, years before he entered the financial industry.

He was in the computer components business in the early '80s, when products were developing quickly and demand was booming.

"I needed money fast, due to the window of opportunity," he said.

Sheehan took $40,000 out of his $60,000 IRA. Within 10 years the enterprise became a $40 million business.

Was he afraid of the large withdrawal?

"No," Sheehan said. "I knew it was going to be a success, and I would do whatever it took. You have to have a certain mind-set to make something real out of a dream."

He wonders if it was the right decision, though.

"In retrospect, I gave up a lot, but the business was successful," he said. "However, who knows what the value of my IRA may have become if I left it alone, as this was in 1982 and the markets had a pretty good run from there." — D.N.


— By Deborah Nason, special to CNBC.com