BUYING A BUSINESS

Mar 16, 2022

Using a 401(k) to Buy a Business

Like any fiscally responsible employee, you’ve been diverting a healthy percentage of your salary into a 401(k). It has grown over time and you are content with the return. You have recently come across an attractive business that’s for sale, but your capital is tied up in other projects. You don’t want to take out an SBA loan or ask relatives for a loan.

Although the 401(k) plan is a retirement account and is typically only cashed out after retirement, there are options available to you to use it however you want. In this case, you want to find out how you can use your retirement account—money you own—as business financing to buy an existing business. 

Option 1: Rollover for Business Startup (ROBS)

Rollover for Business Startups (ROBS) is the most likely route you can take to buy a business with your 401(k). This method allows you, as a future business owner, to tap into your retirement funds in a tax-advantaged way. This process “rolls over” your existing retirement plan into the new company in exchange for stock that you issue to yourself. By far, the greatest advantage of using a ROBS is being able to invest your retirement savings in a small business entirely tax-free. 

Setting up a ROBS is not overly complicated, but it is important to follow the procedure defined by the IRS in order to avoid tax complications or other compliance issues. There are providers who will provide the service for you for a rate of around $4,000.

These services, or any business accountant, can help you set up the required C Corporation paperwork and issuing the Qualified Employer Securities (QES) can be somewhat involved. Once it is set up, your retirement plan, now issued by the C Corp, purchases stock in the newly-formed company.

Many people find that they are able to set up a ROBS without paying for an all-inclusive service. In order to roll over your 401(k) into this structure, you need to follow five key steps.  

• Form a C Corporation for the new business

• Set up the qualified retirement accounts for employees of your C Corp

• Roll over your existing retirement account into the new C Corp’s plan

• The retirement plan in the C Corp purchases stock in the C Corp. This type of transaction (QES) is only possible in a C Corp

• The business receives the proceeds from the stock sale and are available for business use 

ROBS Advantages

There are a number of advantages to using a ROBS structure. As mentioned above, the tax-free, penalty-free usage of your retirement account is the most obvious. People looking to buy a business will do whatever they can to minimize transfer and purchase costs, and ROBS can be a great way to fund a purchase.

The Employee Retirement Income Security Act (ERISA) is a federal law that was enacted in order to protect the retirement accounts of American workers. ERISA covers a number of retirement plans, 401(k) included, as well as some private sector plans. This law guides retirement account adherence and should be a companion when setting up a ROBS. When using a ROBS, you become an employee of your new business. 

ROBS structures are also a fairly quick process. In reality, it will probably take longer to fill out the paperwork than it will take to wait for acceptance and clearance. For most, the entire ROBS process only takes a few weeks. When you consider the time it takes to get an SBA Loan or to procure other funding, it becomes immediately clear that using your 401(k) to buy a business is certainly an expedient method.

Your 401(k) has advantages outside of simply being a retirement account

C Corp’s have their own benefits. For example, profits from a C Corp are not taxed at nor do they affect an individual’s tax bracket. The profits from the C Corp are taxed at the corporate rate. When you compare the C Corp tax rate, which is 21%, against individual income tax brackets which can be as high as 37%, you can see why a C Corp has further tax advantages than simply avoiding a 401(k) early withdrawal penalty. Do be aware that drawing income for your C Corp will result in double taxation: not only do you get taxed at the corporate level, but you would also pay income tax for anything you pay to yourself.

There are other benefits to C Corp’s themselves, such as being able to deduct health insurance costs paid for employees, paying salaries in a way that depletes taxable profits, and the ability to decide exactly when to file fiscal year reports. 

ROBS Disadvantages 

There are some disadvantages to using your 401(k) to buy a business using ROBS. There is the paperwork involved and the filing requirements: annoying to some, and incomprehensible to others. The IRS does not particularly enjoy when people make a mess of their 401(k) rollovers, so if this is a route you want to take, make sure everything is perfect before filing. 

Although we all start businesses in order to make a profit, the reality is that a good number of small businesses fail. In fact, when the IRS initiated and pursued a ROBS compliance project (with the inspirational title of “Rollovers as Business Startups Compliance Project”) they made a point to mention that most ROBS failed or were sold while “on the road to failure.” They further write/warn that it’s not only possible to lose the business, but the entirety of their retirement savings if the business fails. The question becomes: does your personal risk tolerance align with the high-risk nature of running an SMB? While buying instead of starting helps de-risk the investment, you are still likely running a higher risk of a bad outcome than you would be with a diversified portfolio. 

The main disadvantages to using a ROBS structure is that ROBS are more complicated than a loan and puts your retirement savings at risk. For this reason alone it could be considered a risky method of funding a business; but if you do your due diligence and have a solid plan, ROBS can be a great way to use your 401(k) to buy a business. 

ROBS Frequently Asked Questions

Do I have to quit my job to start or buy a business with ROBS?

The answer is that it depends. Some ROBS-eligible retirement plans prevent performing a ROBS when the plan is tied to an active employee, in which case you would need to leave your job. However, there are a few carve-outs:

• You have a retirement plan from a previous employer that has enough funds for a ROBS

• Your current retirement plan allows an in-service rollover

• You're more than 59 1/2 years old

Do I need to invest my entire retirement plan when using ROBS?

No, you can use as much of your retirement savings as you want. In fact, you're able to do an Additional Rollover Capital (ARC) transaction if you decide that you need to roll over additional funds after the initial transaction.

Is ROBS limited to only assets in 401(k)s?

No, nearly any retirement plan can be used with a ROBS. The distinction is that the retirement plan needs to be rolled over into a 401(k) at the new company. Think of it as the "starting point" and "destination." The "destination" is always a 401(k) at the new C-Corp. The "starting point" can be a Traditional IRA, SEP-IRA, SIMPLE IRA, 401(k), etc.

Option 2: Taking Out a 401(k) Loan

If you have determined the ROBS method might not be for you, you can always buy your business with a loan taken from your 401(k). In many cases, this can provide a significant advantage over other loan types as you are lending yourself the money while putting up your own collateral. You should discuss the best way to process this loan with your plan administrator. 

Taking out a 401(k) loan is also much easier than pursuing a ROBS strategy. Just like ROBS, you are able to take a 401(k) loan without incurring penalties from the IRS. You still pay interest on the loan but you pay it back to the lender (which is you), so the interest paid will be paid back into your own account. This alone makes it a better option than a private business loan and the resulting business debt.

Working with a qualified accountant can save time and money when dealing with taxes

You are able to take a loan for $50,000 or as much as 50% of your savings, within a 12-month period. The loan itself has an amortization period (required payment timeline) of five years. If for some reason you fall behind on the loan, it may be reported to credit bureaus, which could lower your credit score. If you truly can’t repay the loan, the IRS requires you not only to pay taxes on the defaulted amount, but you incur an early withdrawal penalty of 10% if you’re under 59½ years old. 

When you take out a 401(k) loan, you are reducing your invested retirement assets. If you take out a loan and your investments that remain in account rise substantially, you will miss some of those gains since the money has been appropriated to the loan, not securities. Make sure to discuss the limitations of your particular situation with your 401(k) provider: in some instances, you may be unable to contribute to your 401(k) during the repayment period. 

Taking out a 401(k) loan to buy a small business isn’t as advantaged as a ROBS account, but it is still a healthy way to fund a purchase. You are not only able to sidestep the early withdrawal penalty, but you are essentially able to take out a loan with a zero percent interest rate to pay for your purchase.  

Option 3: Early 401(k) Withdrawal 

In an emergency situation, taking an early 401(k) withdrawal can make sense. You will pay significant penalties for doing so, and it can have a noticeable effect on your retirement accounts and long-term investment returns. If you are looking to buy a business using your 401(k), this is the least desirable of the financing options covered in this article. 

Typical reasons to make an early 401(k) withdrawal are if you need to make a payment immediately in order to avoid repossession, to cover a costly emergency vehicle repair, or in other emergency situations that require access to money you just don’t have. If you have an accountant, they will probably advise you that taking an early withdrawal should only be seen as a last resort. 

There are, however, some circumstances where you may not have to pay the early withdrawal fee. If you lose your job and are 55 years old or older, you won’t have to pay the 10% tax penalty. There are sections in the CARES Act, specifically section 2202, that allows favorable tax treatment for up to $100,000 of coronavirus-related distributions from eligible retirement plans. These include individual retirement accounts (IRAs), 403(b) plans, and 401(k) plans. 

That being said, you need to be considered a “qualified individual” under the section. The list of what makes you a qualified individual can be found here. There are also adjustments to loan relief and if you qualify, may be able to take a higher loan amount if you borrow against your 401(k).

Due to the 10% penalty levied by the IRS, as well as income taxes being due on the withdrawal, there are not many benefits when considering an early withdrawal in order to buy a business. Taking out a 401(k) loan is almost always the better choice, especially if you are a qualified individual under the CARES Act.  

The Bottom Line 

There are a few options for entrepreneurs to use a 401(k) to buy a business. Although it can seem daunting to pursue a ROBS or take a loan out against your retirement account, the benefits of doing some financial legwork can make your 401(k) a better option to finance a business purchase when compared to SBA or direct loans. Working with a small business advisor will pay itself back over time and can be a trusted companion throughout the purchase of a new business, especially when considering the importance of your hard-earned retirement money.

Mitchell Grant

Content Writer

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.