If you want to start a business that requires significant capital—think a restaurant, or buying a franchise—you either need to qualify for a startup small business loan, find an investor, or have cash to invest. 

What if you have money saved, but it’s tied up in your retirement savings? 

For some would-be entrepreneurs, that’s a real possibility.  More than 885,000 401(k) plans have at least $1 million in  employer-sponsored plans (such as 401k or 403b plans) and individually controlled IRA savings and investment accounts, according to Empower Personal Dashboard^TM data as of March 2024. 

Even  if you don’t have a million-dollar retirement savings account, you may want to tap your retirement accounts for business funding.

One way to do that is with a Rollover Business Startups (ROBS) account. Here’s how they work, and how to decide if one is right for you. 

What is a ROBS 401k (Rollover as Business Startups)

A Rollover as Business Start-up (ROBS) offers a way to use retirement funds to start a business without cashing in your IRA, 401(k) or 403(b) savings.

Normally, if you want to use retirement savings in a 401(k) plan, you either need to:

1. Withdraw fund from your account, which has tax implications and may result in early withdrawal penalties, depending on your age, or 
2. Get a loan from your 401(k) or 403(b) account and pay it back in monthly payments over 5 years. (And many plans require you to repay the loan immediately if you separate from your employer.)

A ROBS plan can bypass those concerns. Here’s how it typically works:

Step 1. Create a C Corporation. The business owner sets up a new C Corporation, a type of company structure that allows for the issuance of stock.

Step 2. Establish a Retirement Plan. You’ll then establish a new retirement plan, such as a 401(k), profit-sharing, or defined-benefit plan, for that corporation.

Step 3. Roll Over Retirement Funds. The business owner rolls over their existing retirement funds from their existing retirement account, such as a former employer’s 401(k) or their IRA, into the new retirement plan.

Step 4. Invest in Company Stock. The retirement plan then uses the rolled-over funds to purchase stock in the new corporation.

Step 5. Use the Capital. The corporation uses the capital generated from the sale of stock to fund the start-up costs of the new business.

If it sounds a bit complicated, it can be. Setting up one of these accounts is not inexpensive, and It must be handled very carefully to avoid running afoul of the IRS. A misstep can be expensive, resulting in unexpected income taxes and/or penalties. 

Pros of Using a ROBS to Fund Your Business

The main benefits of using a ROBS account are:

• No loan qualification requirements such as good credit scores, business revenues, etc.
• Avoid taxes required when withdrawing funds from retirement accounts to start a business.
• No need to take a loan from a retirement account or make payments. 

“Using a ROBS to fund a business comes with several appealing advantages,” notes Eric Croak, CFP, Accredited Wealth Management Advisor, and the President of Croak Capital, a wealth management firm in Toledo, Ohio.

“Primarily, it allows for funding without incurring any debt since it’s not a loan but a leveraging of your retirement account. This also means there’s no interest to worry about, so all the funds can be directed into growing the business.”

He also notes that business owners don’t need good credit scores or proof of revenue to qualify. And, he points out that these plans don’t require “personal guarantees or collateral requirements, which protects personal assets outside of the retirement funds being used.”

Cons and Risks of Using a ROBS to Fund Your Business

The cons ROBS funding include:

• Can be expensive to set up and administer. 
• There are ongoing steps that must be met to keep the plan in compliance. 
• The IRS has raised warnings about these plans, and compliance is crucially important to avoid an IRS audit that could result in taxes and/or penalties. 

When the IRS studied these plans in its Employee Plans (EP) ROBS Project, it found that many businesses funded through ROBS ultimately fail, leading to the loss of retirement savings. It found high rates of bankruptcy, liens, and corporate dissolutions.

“The most significant risk is the potential total loss of retirement funds invested if the business fails,” Croak warns. “This is a serious consideration as it could impact long-term financial security.” 

And though there is no interest or loan fees, they aren’t without costs. “There are setup fees and ongoing maintenance and reporting fees required by most ROBS providers,” he points out. 

Finally, Croak warns that “establishing a C-corp for a ROBS plan could lead to higher tax liabilities compared to other business structures. Incorrect setup can also lead to penalties from the IRS, emphasizing the importance of choosing a knowledgeable ROBS provider.”

How To Know if a ROBS Plan Is Right for Your Business

First, it’s important to be realistic about your retirement savings. Most Americans do not have sufficient retirement savings. What happens if your business fails? Not only will you likely lose the money you need for retirement, you will have likely paid several thousands of dollars in fees. 

Second, you need to be realistic about the likelihood of success for your new business. ROBS financing is most often used successfully by individuals who have sufficient retirement savings, and who invest in franchises or relatively low-risk businesses. 

Third, it’s important to work with a reputable ROBS provider to help you set up your plan. Vet them carefully and consider getting a second opinion from your own advisors. 

Alternatives To Rollover for Business Startups to Finance Your Small Business

While it can be more challenging to get business financing for a startup, there are several options prospective business owners can explore:

SBA loans

The U.S. Small Business Administration oversees the SBA loan program. There are several types of SBA loans, including 7(a) loans, SBA Microloans, 504 loans, and more. These loans are made by lenders approved by the SBA, while the SBA guarantees them. Some lenders make SBA startup loans; you generally need good credit to qualify. 

Online loans

A wide variety of lenders offer small business loans including business lines of credit, term loans (loans for a fixed amount of money usually paid back over a set period), as well as business cash advances, which are usually based on business revenue. You’ll typically need business revenue to qualify. 

Business Credit Cards

Most business credit cards offer a line of credit that lets them access funds quickly. Even better, they are often available to startups provided the owner has good personal credit and qualifying income from all sources. Plus, most small business credit cards can also help your business establish business credit scores if you pay on time. 

Crowdfunding 

One advantage of crowdfunding is that a business doesn’t have to be established to potentially raise money. Great ideas, combined with great marketing, can help a business get funding. The main types of crowdfunding for small businesses include rewards-based crowdfunding, investment-based crowdfunding, loan-based crowdfunding.

How To Set Up a ROBS

Most small business owners need to hire help to set up one of these plans. Pick your partner carefully. Examine the company’s experience with setting up and administering ROBS plans. Make sure you’ll get ongoing support to ensure your plan continues to comply. 

It’s also a good idea to get a second opinion from an attorney or your accounting professional. 

How To Prevent a ROBS 401K Nightmare

There are a number of actions that can put you in hot water with the IRS. In 2008, the IRS published a Memorandum that described some of the problems it had identified. These are still relevant today.

It warns of two primary problems:

1. “Because ROBS transactions generally benefit only the principal involved with setting up a business, and do not enable rank-and-file employees to acquire employer stock, we believe that some of these plans violate the anti-discrimination provisions of the Code and Regulations, on a case-by-case basis.
2. In all ROBS arrangements, an aspiring entrepreneur creates capital stock for the purpose of exchanging it for tax-deferred accumulation assets. The value of the stock is set as the value of the available assets. An appraisal may be created to substantiate this value, but it is often devoid of supportive analysis. We find this may create a prohibited transaction, depending on true enterprise value.”

Elsewhere in the memorandum, the IRS points out common “disqualifying operational defects”: 

“We have examined a number of these plans…and found significant disqualifying operational defects in most. For example, employees in some arrangements have not been notified of the existence of the plan, do not enter the plan or receive contributions or allocable shares of employer stock. 

“Additionally, we have identified that plan assets are either not valued or are valued with threadbare appraisals. 

“Required annual reports for some plans have not been filed. In several situations, we have also found that the business entity created from the ROBS exchange has either not survived, or used the resultant assets on personal, nonbusiness purchases.”

How do you avoid these problems?

As mentioned above, it’s important to work with a reputable company to make sure your plan is set up properly. 

It’s also crucial to understand what you can and cannot do with one of these plans. For example: 

Your business must be a C corp and must maintain that status. 

You can’t use this type of plan to fund a passive business, such as certain types of real estate investments. And you can’t be a passive employee in the business.

ROBS plans are not meant to be a personal piggy bank. You must avoid using funds for personal purposes and you can’t pay yourself excessive compensation for your work in the company. 

You must offer eligible employees the opportunity to participate in the retirement plan, and you must pay Fair Market Value for your company stock. 

Annual filings are required. 

Navs Verdict

ROBS can be a viable funding option for your new business venture. But it requires careful planning and compliance with IRS regulations. 

Before deciding to go the route of a ROBS arrangement, make sure you consult with a qualified tax advisor or attorney to ensure that you fully understand the implications and maintain compliance with all legal requirements. 

Also explore other financing options to determine whether you can fund your business without using retirement funds. 

By doing your due diligence, you can help protect your retirement savings and set your business up for success.