Looking forward to retirement as a time to start that business you’ve always known you could run? Be wary of using your retirement money as seed money, lest its pros turn into cons.
According to a NerdWallet report, while there’s a retirement account option for launching a business—known as a Rollover for Business Startups, or ROBS—there are reasons to be very careful if you take this route to entrepreneurdom. Says the report, “While this type of financing can provide you with money to fund your business, the complex transaction doesn’t make sense for everyone.”
You can use funds from eligible retirement accounts, including a 401(k) or a traditional individual retirement account, to launch a business. The accounts get rolled over (usually with help from an attorney or a ROBS provider) so that you can use the funds either to invest in a new business or franchise or even buy or put money into an existing business.
A C corporation gets formed, along with a new 401(k) plan for the business, and then the buyer’s existing retirement accounts get rolled over into the new 401(k). Once that’s done, the money in the new plan is used to buy company stock in the new C corporation so that the money from the sale of stock is the cash that’s invested in the business.
That allows the new business owner to avoid the necessity of needing strong personal credit, positive cash flow and collateral for loan approval—a means for someone with healthy retirement savings but maybe no other loan qualifications—to be able to launch the business.
It’s also not a loan, so there are no loan payments hanging over your head, meaning that you can reinvest any profits back into the business instead of having to make payments on a loan and lose profits to interest charges.
In addition, if you take money out of a 401(k) or IRA before you turn 59½, you’ll get slammed with early withdrawal penalties and a distribution tax. But if you take those funds out to get a ROBS, that’s not the case.
Lest you rush off half-cocked to go start that business you’ve always dreamed of, remember the cons: It’s your retirement money that’s at risk. If the business fails, you have no retirement.
You’re also foregoing any chance of asset growth within a retirement account; if the business doesn’t grow, you’ll miss out on compounding and any rise in the markets that your 401(k) could have taken advantage of.
Also, you’ll have to operate as a C corporation, whether or not that particular business structure is good for your business taxwise—not as a sole proprietorship or a limited liability company. And you’ll pay—a lot—in fees to pull this off and be more prone to audit by the IRS.
So before you take the plunge, talk to the experts and make sure it’s what you really want to do.
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