For most people who are considering starting a business, the biggest challenge is securing legitimate financing. One option for aspiring business owners who contributed to a 401K through a previous employer or have their own Individual Retirement Account (IRA) is to use those funds for business start-up costs. This method is called Rollover as Business Start-Ups (ROBS).
The first step for new business owners using the ROBS method is to incorporate their new start-up company. Upon incorporation, the new C-corporation owner can rollover his or her existing 401K or IRA funds into the retirement plan he or she set up under the new corporation. The person initiating the rollover is not required to pay taxes on the funds used to establish the new account.
After the successful rollover of funds, the owner of the new C-Corporation needs to initiate a qualified employer securities transaction. The person in charge of the retirement account can buy shares and funnel the proceeds back into the business. Many entrepreneurs prefer 401K financing because it allows them immediate access to working capital without having to worry about large payments before the company is profitable.
It’s extremely important for anyone relying on retirement financing to understand applicable tax laws regarding the funds transfer. Developing a solid business plan is also essential to help avoid poor investment choices. Business owners must understand that not doing so could cause them to deplete the funds in their retirement account.
Consider the Pros and Cons
As with all types of business funding, people who are considering using retirement financing should carefully weigh the benefits and possible drawback before committing to it. The two biggest benefits include:
Easier funding: Many banks are still conservative with lending practices after the last recession. The ROBS method allows entrepreneurs fast and easy access to cash without taking on credit card or home equity loan debt.
Tax deferral: 401K financing allows new business owners to shield the funds in their retirement account from immediate taxation. Also, the IRS doesn’t set a limit on business financing using the ROBS methods.
Some potential problems associated with using 401K financing include greater IRS scrutiny and chances of an audit as well as the possibility of losing retirement funding due to business failure. People who take the time to analyze their risks and create a strong business plan tend to do well using retirement financing to start a business.