If you’re looking for startup or operating capital for a business, you might exhaust all debt and equity financing options before discovering that Rollovers as Business Startups (ROBS) could have been a great option from the start.
Accessing the capital needed from your own accounts can be a great way to avoid the risks of assuming debt, but it can also come with its own set of risks. If you are a young entrepreneur without any money saved in a 401(k), ROBS will not be a viable option to you and you should consider alternatives to raising capital, such as equity crowdfunding.
In this article, we cover what ROBS is, how it works, and the pros and cons of using this method for raising startup capital.
What is ROBS?
Rollovers as Business Startups (ROBS) is an IRS initiative that allows Americans to withdraw from their 401(k) accounts without incurring withdrawal fees and still maintain tax-deferral. The proceeds of the withdrawal can be used to start a business, buy a business, or purchase shares of equity in the C-corp, which will be owned by the 401(k) plan.
ROBS do not function as traditional loans or a 401(k) loan, so they don’t carry interest or a repayment period.
How does ROBS work?
When you rollover your 401(k) in the form of a ROBS transaction, you are essentially liquidating your existing retirement account positions to purchase stock in the new or existing private corporation.
The new company you wish to start or the existing company you wish to purchase must be incorporated as a C-corporation, which comprises shares of stock and a qualifying employer security. Then, the corporation establishes a new 401(k) plan, which cannot be an IRA. The entrepreneur can roll their existing 401(k) into this new plan, establishing the etymology for the “R” in ROBS.
Once the funds are rolled to the new plan, they can be used to purchase shares in the C-corp, effectively infusing the business with the needed cash, and the 401(k) plan with shares of the business. This means that if and when you sell your business, the proceeds from that liquidity event will transfer to your retirement plan.
It’s worth mentioning that the ROBS does come with its share of responsibilities and requirements enforced by the IRS. The IRS requires that the plan be an Eligible Individual Account Plan (EIAP), typically a 401(k). Since the retirement plan is also available to employees, it must also meet certain filing requirements.
Form 5500, for example, must be filed annually with the IRS and Department of Labor (DOL) with a business valuation and value of assets in each employee’s retirement account.
Many people use ROBS to purchase a franchise business and essentially buy themselves a job with a regular salary. The IRS actually requires that the ROBS participant be a salaried employee of the business and work a minimum of 1,000 hours per year — about 20 hours per week.
Advantages of ROBS
When the option is available, the ROBS can have many advantages for funding a new or existing business.
1. Avoid Tax and Distribution Penalty
One of the main benefits of a 401(k) is its tax deferral, allowing the principal to grow tax-free until the cash is distributed for personal use. Although you are technically using your 401(k) capital to fund your business, which can feel like a personal distribution of the funds, it is actually viewed as an investment on behalf of the 401(k) and therefore preserves the tax deferral structure.
In the event that you, the entrepreneur and ROBS participant are not over the age 59½ — the age when 401(k) distributions become available without an early distribution fee — the ROBS transaction is viewed as an exception and therefore does not incur the distribution fee.
2. Alternative to Debt
Another benefit of ROBS is its terms are the antithesis to those of debt financing. For example, ROBS is not a 401(k) loan or other vehicle that comes with a regular repayment schedule or interest rate.
The potential for the 401(k) to see a return on the ROBS investment is through acquisition or other liquidation of the business.
Disadvantages of ROBS
In addition to the requirements we’ve mentioned throughout this article that would prevent the ROBS from being accessible, including:
- Lack of existing 401(k) retirement plan
- Use of an IRA instead of 401(k)
There are also a few disadvantages that can come from using a ROBS:
1. Retirement at Risk
One of the most prominent risks is robbing yourself of the returns that would otherwise have accrued in your 401(k) had you not rolled it into a fledgling business. It’s an unfortunate reality that most businesses fail, and using the money from your retirement account to fund a business is not always the most prudent investment.
This is why many people use ROBS financing to franchise a proven business model, which can carry less risk compared to an entirely new business and unproven business model.
2. C-Corp Structure
Some businesses are not ideal for the C-corp structure, which is why other structures, such as LLC and S-corp, among others, exist. For example, If your business makes regular distributions to investors, the S-Corp structure prevents double taxation from both the corporate and personal levels and has other benefits.
It’s worth noting, however, in the best case scenario — the business is successful and you are able to sell it, you can avoid capital gains tax and it’s even possible to convert your 401K (including the appreciated stock in the C-corp) to a tax-free Roth IRA.
Should You Use ROBS?
Ultimately, the decision of whether or not to use the ROBS to leverage your existing retirement plan to fund a new business is yours to make. Without the specifics of your situation accounted for, we have put together a flowchart below to help guide your decision compared with alternatives such as the 401(k) loan and a standard distribution.
In some cases, such as when the amount of funding needed is less than $50,000, a ROBS doesn’t make sense. There are costs associated with incorporating the new business, establishing a new 401(k) plan, and the ROBS transaction itself — not to mention ongoing filing and associated costs.
In those scenarios, it might be worth exploring a 401(k) loan which is an interest carrying vehicle but the debt is simply repaid to your 401(k) account. Another option is to simply take an early distribution incurring the fees and taxes that can total about 30% — or 20% for those over 59 ½ years of age.
Best ROBS Providers
The process of rolling over your 401(k) in the form of a ROBS transaction is not as simple as transferring funds from one bank account to another.
As is the case with most complex, one-off transactions, it’s best to leverage the knowledge of those who do them everyday. Just like investment bankers help with the IPO process, ROBS providers help efficiently access your retirement funds for business use. Below are some ROBS providers that come highly recommended:
1. IRA Financial
The founder of IRA Financial, Adam Bergman, literally wrote the book on legally redirecting your retirement funds into alternative investments. Their ROBS solution incurs a one-time fee of $2,500 for helping to establish the shell corporation, setting up the new 401(k) plan, transferring funds from the previous plan to the new plan, and filing all the necessary disclosures.
IRA financial also charges a monthly fee of $100 for ongoing processes and legal filings. IRA Financial’s mobile app and product feels the most modern and sophisticated, which could be worth the investment alone.
2. Guidant Financial
Guidant has a ton of business funding products and services, one of which is their ROBS offering. Guidant touts their easy qualification process, not requiring collateral nor an impeccable credit score.
Guidant’s one-time setup fee is nearly $5,000 and the ongoing monthly fee is about $140. This is a bit pricier than IRA Financial, but could be beneficial given the large amount of complementary financial services they can provide.
3. My Solo 401k
The ROBS solution from MySolo401k is unique in that it offers a flat fee structure with an annual fee starting after the first year in lieu of a recurring monthly payment. Typically, the one-time fee is $5,000, but due to the COVID-19 pandemic’s impact on Americans and small businesses, they are offering a limited-time discount of $1,000 off, bringing the fee down to $4,000.
The annual fee is $899 which equates to less than $75 per month.
Startup Capital Alternatives
We believe the ROBS program is a great option for those who have built up substantial savings in their 401(k) and have the skills needed to start and operate a business. The way we see it, the more funding options available to entrepreneurs, the better.
As innovators in the business funding space, with patents awarded for our equity crowdfunding and business planning tools, EquityNet is driven to facilitate value creation in global entrepreneurship. Sign up now to learn how you can invest in the future you believe in or raise capital to build that future.