How to Fund Your Business Purchase with Your 401(K)
Unleash Your 401(K) Potential
Thanks to the federal government’s Employee Retirement Income Security Act of 1974 (ERISA), you can use your IRA or 401(k) funds to buy a business without incurring penalties. Bank loans and other funding can be combined with your retirement account money to create extremely flexible financing options. The practice of starting or acquiring an existing business with retirement funds is so popular it even has a cool acronym: ROBS (Rollovers as Business Startups).
A Rollover for Business Startups allows you to use your retirement account in a highly tax-advantaged way for the purchase of a business and it need not be a startup. Rolling over your existing retirement plan into the new company (NEWCO) in exchange for stock in NEWCO. Investing in a small business entirely tax-free is the biggest advantage of ROBSs.
To avoid tax complications and IRS compliance issues, it is important to follow all IRS instructions when setting up a ROBS. It may be necessary for you to seek assistance in setting up the necessary C Corporation paperwork and issuing the Qualified Employer Securities (QES) The QES represents the stock equity issued by NEWCO. Your retirement plan created by C Corp NEWCO will purchase stock in the newly formed company once it is set up.
5 Step Process
To roll over your 401(k) into the NEWCO retirement account and corporate structure, you need to do the following:
- Create a C Corporation for your new business entity NEWCO
- Create Qualified Retirement Accounts for the employees of NEWCO
- Roll over your existing retirement account into the NEWCO retirement account
- The retirement plan of NEWCO will then use the funds to purchase the stock in your newly created C Corp. This type of transaction can only occur with a C Corp structure as a sole proprietorship, partnership or LLC cannot issue stock which is required to make the ROBS work properly
- The business gets proceeds from the stock sale and the funds are available for the acquisition
The Big Advantage
There are several advantages to deploying a ROBS acquisition strategy.
- Tax-free, penalty-free access to your retirement account is one such advantage. When acquiring a business, it is wise to minimize expensive transfer and purchase costs, and ROBS is a slick way to fund a purchase while avoiding costs
- ROBS plan can be created with a relatively quick process. The typical ROBS process normally takes a few weeks. When you compare it to the time it takes to apply for an SBA Loan or other funding options, you see that using your 401(k) to buy a business is indeed a fast and efficient solution.
- Your 401(k) is now a major business acquisition funding source and no longer a simple old-age account.
C Corporation Advantage
The profits from the C Corp are taxed at the corporate rate, not your individual income tax rate. Comparing a C Corp tax rate of 21%, to the top individual income tax bracket which was 37% in 2022, it is clear a C Corp with a ROBS plan has more tax advantages than simply avoiding a 401(k) early withdrawal penalty.
- There are other benefits to the C Corps themselves, such as the deductibility of employee health insurance costs and paying salaries in a way that drains taxable corporate profits.
- Some years down the road after you have built a profitable business and you may be ready to sell your company for a large profit. When the shares of stock in your C Corp sell for a profit, the capital gain lives inside your 401(K) consequently you will not incur a capital gains tax on the sale until the funds are taken out of your retirement account.
Don’t Overlook the Downside
There are also some disadvantages to using your 401(k) to buy a business using a ROBS plan, such as:
- The paperwork and filing requirements for a ROBS are sizable
- The IRS does not like when people use their 401(k) rollovers creatively, and you might be more likely to trigger an audit
- While you expect to make money with your new business endeavor many small businesses fail. Meaning it is possible to lose the business and the entirety of your retirement savings.
- Using a ROBS plan is that it is more complicated than a loan and puts your retirement savings at risk.