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.
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