Many of our clients have always dreamed of starting a business. Times are tough, though, and despite many years of experience in the workforce, they know their chances of getting a bank or small-business loan are slim.
But there’s a way to put their years of work to use, The New York Times says — by tapping into a 401k plan to open a “rollover as business start-up,” or ROBS. (https://tinyurl.com/pln9r78) Clients can use a percentage or their entire 401k and won’t incur the typical 401k income taxes and 10 percent fee if they’re younger than 59½.
But as Reuters notes, the ROBS loophole is complex, and it comes with strict rules and regulations that your client must follow or risk running afoul of the IRS. (https://tinyurl.com/p4khpk9)
If your clients are considering a ROBS, it’s important that you explain the strategy — and its risks — clearly.
How a ROBS works
When a client takes money out of her 401k for a ROBS start-up, she uses it to create a C corporation. These are different from most small businesses, The Times reports, which are set up as S corporations or limited liability corporations. The C corporation can issue shares and doesn’t prohibit ownership by trusts.
The new corporation starts its own 401k plan, Bankrate says, and it must offer employees, including your client, the option to buy stock in the new company. Your client then rolls over the money from her 401k into the new corporation’s plan. From that, she can use the funds to buy a franchise or fund the new company. Essentially, it’s tax-free working capital. (https://tinyurl.com/phlcxgt)
Tax-free doesn’t mean headache free, however. Besides the IRS, your client will be dealing with the Department of Labor, which holds jurisdiction over 401k plans. Failure to dot the I’s and cross your T’s could lead to penalties or having the retirement plan disallowed and a huge tax bill.
Even if your client does everything correctly, there are still risks — big risks. Reuters quotes U.S. Bureau of Labor statistics in noting that only half of new businesses survive to their fifth year. At 10 years, the figure is one-third.
It helps if your clients have significant 401k assets to begin with. For them, taking out $150,000 to start a ROBS business won’t mean the end of their savings if it fails.
They’ll need an attorney or CPA to handle the formation of the ROBS corporation and the new retirement plan. These professionals need to know the Employee Retirement Income Security Act, or ERISA, which contains many of the laws that regulate employee benefit plans.
Another option: taking out a loan against the 401k, this is capped at $50,000. If your client needs more, she would be better off taking the money out and paying income taxes and a penalty if necessary. Then she could set up an S corporation, which allows your client to take losses on her tax return, which she can’t do through a ROBS corporation.
And so, while a ROBS can offer significant tax protection, it isn’t without significant risk. Educate clients on both. If you have a specific client who wants to explore this option, our office is here for you.
We hope this information was useful to you and helps your clients and their families. If you have a specific case or a question, don’t hesitate to call our office.