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Would you use your retirement fund to start a small business?

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would you use your retirement fund to start a small business?

Many of us dream of owning a small business, but only a few have the liquidity to get things off the ground. Banks have tightened their lending policy and it can be very difficult for entrepreneurs to get a loan. One way to fund a start up is to use your retirement accounts. I just found out that you can do this without having to pay tax and the usual 10% early withdrawal penalty. This is called a “rollover as a business start-up” (ROBS) and here is how it works.

Rollover as a business start-up

  • You register a C corporation and sponsor a qualified retirement plan.
  • Then you rollover your pretax retirement account (401k and IRA) to the new retirement plan.
  • The retirement plan can use the money to buy stocks in your new company.
  • The company now has cash to spend on inventory, salary, and other startup costs.

This is a pretty cool financial trick. This sounds like a great way to channel your pretax retirement funds into a business, all while preserving the tax-deferred status. The alternative is to withdraw the sum from your IRA (or 401k) and use that to fund a business. You’d have to pay a lot of taxes with a big withdrawal like that, though. Your million dollars can be reduced by almost half especially if you already are in a high income tax bracket and have state income tax. That’s a big chunk already gone even before starting a business.

You can’t use Roth accounts for ROBS because that money is post tax.

What’s a bit unclear is how you would get your retirement money back. I guess when you sell the business, all the proceeds will go into the retirement plan and then you can roll it over to an IRA.

Small Business

Personally, I would not use my retirement fund to start a small business. That fund is for retirement and I would hate to use it for anything else. By my estimate, we should have enough to fund our retirement with a little help from social security. We are already set there so I don’t want to risk that phase of our lives. Why take on more risk when you have already won?

I’d rather start a micro business that I can fund with my after tax accounts. I probably wouldn’t invest more than $50,000 in a business. That’s just me, though. I’d rather start lean and make less money than swing for the fence. I’m just more attracted to microbusiness* for some reason.  (I guess because I’m already working in one.)

*Microbusiness – a type of small business that has five or fewer employees and requires seed capital of less than $35,000.

You can get a microbusiness going with a little cash investment and a lot of sweat equities. You’d need a lot more capital to start a small business like a Subway franchise or a convenient store. The opportunity for profit is better with a bigger initial investment, but it’s a lot of money just to open the door. The small start up cost of a microbusiness also opens more avenue of funding. You can borrow from friends and family or try peer to peer lending. If your credit is good, you can borrow up to $35,000 from Prosper.com and up to $100,000 from Lending Club.

I’d probably go with peer to peer lending or even a home equity loan. I’m just really reluctant to touch our retirement account. About half of all new small businesses fail within the first five year. I wouldn’t bet my retirement on those odd unless I’m really sure of the business.

What about you? Would you consider using your retirement account to fund a business if the right opportunity comes along? 

Photo credit: flickr Rob Boudon

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{ 33 comments… add one }

  • Clarisse @ Savvy Scot March 24, 2014, 1:33 am

    I totally agree with you, for me, I wouldn’t use my retirement savings to fund a small business, maybe I could seek my family’s help or try to get a loan. Retirement savings are very important and I wouldn’t take a risk to use that one.

  • Ernie Zelinski March 24, 2014, 2:04 am

    When I was much younger (in my 20’s or 30’s), I would certainly have used my retirement savings to start a business. Now that I am in my 60’s, definitely not.

    You state, “You can borrow from friends and family or try peer to peer lending.” My motto has always been, “Never lend money to a friend or borrow money from a friend.” If you borrow money from a friend, and are not able to pay the friend back, you will have lost both – the money and the friend. Who needs that?

    Having said that, even in my 60’s I would still start a new business, although I would look for a business that requires almost no or extremely low capital.

    And my inspiration would come from these two quotations that have guided me in the past.

    “When starting out, don’t worry about not having enough money. Limited funds are a blessing, not a curse. Nothing encourages creative thinking in quite the same way.”
    — H. Jackson Brown, Jr.

    “Empty pockets never held anyone back. Only empty heads and empty hearts can do that.”
    — Norman Vincent Peale

    The thing that amazes me is the number of people who will get a buyout of $100,000 or more from a company and then risk the entire amount along with much more on a restaurant or a franchise where the total capital investment can be $500,000. Then they will work 16 hours a day, 7 days a week, for years trying to establish the business. These people are insane. Fact is, there are ways to start a profitable business where the capital investment is really low and one has to work only 4 or 5 hours a day.

    Ernie J. Zelinski
    The Prosperity Guy
    “Helping Adventurous Souls Live Prosperous and Free”
    Author of the Bestseller “How to Retire Happy, Wild, and Free”
    (Over 200,000 copies sold and published in 9 languages)
    and the International Bestseller “The Joy of Not Working’
    (Over 250,000 copies sold and published in 17 languages)

    • retirebyforty March 24, 2014, 9:38 am

      Age does play a big role. When we’re younger, it’s easier to take chances because we have time to recover. My retirement fund wasn’t that big in my 20s anyway. $35,000 isn’t that much to borrow from friends and family, IMO. I should be able to pay it back if I take an extra job for a few years.
      Thanks for sharing the quotes. You’re right about investing so much in a capital intensive business. You really need more cushion.

  • Under The Money Tree March 24, 2014, 4:46 am

    My small [lettings] business IS my retirement fund. I think sthis is a much safer way to do it.

  • David D March 24, 2014, 5:15 am

    I agree, I would not use my retirement funds to start a business. However, I can imagine that many people start a business without using their retirement money, but they end up using it later to keep the business afloat. It is hard to know when to quit pumping money into a losing proposition, especially once you have become emotionally invested into the venture.

    • retirebyforty March 24, 2014, 9:40 am

      I can imagine how hard it is to stop pumping money into a business. You could easily lose everything that way. But who knows when a business could turn a corner. It’s tough.

  • David March 24, 2014, 5:43 am

    I didn’t completely understand what you mean by pretax retirement. What kind of pretax retirement account are you suggesting we could use to fund a small business if not an IRA/401(k)?

    • retirebyforty March 24, 2014, 9:40 am

      It’s just the IRA and 401k.

  • EscapeVelocity2020 March 24, 2014, 5:50 am

    I plan to use my micro business to produce tax advantages on the taxable dividends and interest my after tax investments throw off, so I don’t so a need for an FIRE-type to need to consider this trick. Plus it sounds very risky and like a huge tax reporting hassle when all is said and done. Any idea how things like a home office deduction or business expense deductions would be handled, if you’re paying all the business expenses from this rollover?

    • retirebyforty March 24, 2014, 9:44 am

      I imagine you can just deduct business expense as usual. Once you do the ROBS, the fund is available to use for legitimate business expense. You just do the book and report tax normally. I’m not an expert on this topic so we probably need some help from a CPA.

  • Mike March 24, 2014, 6:14 am

    I think I would rather do a few plasma donations to get the money to get a domain for a few years and just invest in the sweat equity as much as possible. It seems to be much easier that way and you are only looking at a maximum investment of $100-$120 upfront to get things going (you can always do consulting, affiliate offers, ads, sponsored posts, etc initially until you got the money to buy hosting).

    • retirebyforty March 24, 2014, 9:45 am

      I prefer to start small as well. I have plenty of sweat to invest right now. 🙂

  • insourcelife March 24, 2014, 6:58 am

    My approach would be the same as yours – I would never touch my retirement balances to fund a business. If I started a business I would limit my cash investment to what I am comfortable with losing. To me “ROBS” is a great abbreviation symbolic of what you might be doing to your retirement.

    • retirebyforty March 24, 2014, 9:47 am

      I’m sure the ROBS works out for someone, but I’d like to see some statistic. Half of all small business fail within 5 years and that’s pretty scary. I wouldn’t put my life saving on the line for that.

  • Mr. Utopia @ Personal Finance Utopia March 24, 2014, 7:57 am

    I wouldn’t do it. Small businesses have a high failure rate especially in certain industries like restaurants/food service. Using your retirement funds as the cash injection is way too risky. If your business fails, you’ll have nothing. I used to work as a small business underwriter doing SBA loans and, while I never saw anyone do something quite as complicated as a ROBS, I did have loans where the borrowers liquidated portions of their retirement accounts or substantially all of their other investments. In a sense, they were going all in. For some who were buying established businesses in an area in which they had experience, it made more sense. But, others were gambling everything on businesses/industries with high default rates. Crazy if you ask me, but I’m more conservative in nature.

    • retirebyforty March 24, 2014, 9:48 am

      Thanks for your input. Buying an established business is a better idea, but you never know how new management will work out. I wonder how many of those people are successful. Some of them must have done well.

  • davidmichael March 24, 2014, 9:44 am

    Same here. I would never risk my retirement funds for a small business.

    Having said that, and having run a successful small business for 20 years, I would use extra funding to start a one-man business in retirement as you are, Joe, with the blog for instance. Once employees come into the picture, the whole world changes with infinite costs and responsibilities. There’s nothing glamorous about owning a small business. I found it’s incredibly hard work to make a decent living with tons of responsibilities. That’s why four out of five businesses fail within five years. And…then there’s the next five years.
    Been there, done that. Ah! Sweet, sweet retirement where one can call the shots, day by day by day.

  • Pretired Nick March 24, 2014, 9:58 am

    I don’t have a philosophical problem with it. If I had the right idea and I was sure about it, I’d consider it. But I’d never advise someone else to do it. For most people, they’ll be better off getting their retirement under control first, then with that worry out of the way, throwing themselves in full-force.

    • retirebyforty March 25, 2014, 5:20 pm

      That’s interesting. I think some people can take a little more risk than others. My appetite for risk seems to have disappeared as I get older.

  • Done by Forty March 24, 2014, 10:16 am

    With the generally low success rates for small businesses, I would not want to compound that by withdrawing funds from my retirement account to start the company. Your idea of a microbusiness is a great hedge. Emily Capito sent me a great book called the $100 Startup, and the big takeaway I took from it is that initial costs can be avoided if you’re creative and flexible on the kind of business you want to run.

    • retirebyforty March 25, 2014, 5:23 pm

      I read that a while back. It’s pretty good as I recall. There are many businesses you can start these days with minimal funding. The hedge is to have low cost of living so you can get by with the low income for a while. 🙂

  • No Nonsense Landlord March 24, 2014, 8:06 pm

    The answer, It depends. I would not get into a business that I had to hire employees, unless it was something I already know about. Or they were commission.

    Buying a rental property in a 401K is OK, if the deal is right. Investing in equipment after you have signed contracts to do work.

    All you have to do is mitigate the risk, and have some control of the maximum risk.

    • retirebyforty March 25, 2014, 5:23 pm

      That makes sense. You already know rentals so it’s a good place for you and the risk is minimal.

  • Tom @ financeandFlipFlops March 24, 2014, 10:10 pm

    I’m leaning toward the idea that it’s not such a great option, especially for something like a brick and mortar business that requires a lot of overhead and time. If you still have a job it would be incredibly difficult to balance the two. I guess if you’re already financially independent and just haven’t touched your 401k it may not be bad… But at that point why go through the effort to make more money? You already cover your expenses.

    I wonder if you can set up a real-estate investment business and if the timing were right, use the 401k money to force your cash flow earlier collecting rent.

    • retirebyforty March 25, 2014, 5:25 pm

      I think people who did this are in their 40s and wanted their own business. They worked for others for a long time and want to transition. Most of them are not FI. They just want to be their own boss.

  • Retire Before Dad March 25, 2014, 12:29 pm

    I would definitely not use a pre-tax IRA or 401k to fund a business idea, or a house for that matter. Its not the right usage and even with the nifty ROB. But I would consider using money from a Roth prior to age 59 1/2. But only the amount I’ve contributed since it can be taken out without penalty at any time. That said, its highly unlikely I would actually do that. It would have to be a sure thing, and we all know how frequently those come around.

  • Squirrelers March 25, 2014, 1:33 pm

    I wouldn’t fund a small business using retirement funds. I look at those funds as something along the lines of being semi-sacred, in that they’re for the old man version of me down the line!

  • SavvyFinancialLatina March 25, 2014, 7:47 pm

    I would not use my my retirement funds to fund a small business. Retirement should not be touched until retirement.

  • Nope! Retirement shouldn’t be touched until it’s time to retire, in my opinion. I’m sure taking a small business loan at low-interest would be more fruitful, depending on the situation.

    • retirebyforty March 26, 2014, 9:50 am

      As I understand, it’s really difficult to get a small business loan. I’ll need to try it and write about this someday. 🙂

  • John C @ Action Economics March 27, 2014, 9:41 am

    I think its an interesting concept to be able to invest in your own business without withdrawing the money, but it all depends on risk. In my retirement accounts I have a few different index funds, which cover thousands of companies, if any one of them fails, I probably wouldn’t notice it. I view investing my retirement account in my own small business the same as if it was in someone else’s small business. I have to ask, “Would I sell all my retirement account assets in diversified index funds, and invest in ONE penny stock?” Some people can tolerate that amount of risk, I certainly can’t. To start my own business I would either start very small or have a separate savings account earmarked for it and wait a few years.

  • Joe @ Budget Breakaway March 30, 2014, 4:21 pm

    This is an awesome question, I haven’t yet set up my retirement account but I’m fighting the urge to do something entrepreneurial with my emergency fund!

    • retirebyforty March 31, 2014, 10:09 am

      If you’re young, you can probably take more chances. 🙂 Good luck!

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