October 31, 2014

Tapping 401(k) Funds Can Open your Business to Tax Problems

Tapping 401(k) FundsDid you use 401(k) funds to start your business, or are you tapping into your retirement to get you business through the current credit crisis? BusinessWeek recently drew attention to a possible trap:  The IRS is starting to pay more attention to entrepreneurs who finance their businesses using money from their 401(k) funds.

Here’s how such moves typically work: A business owner creates a new corporation, sets up a 401(k) plan for it and moves his or her 401(k) monies into the new plan. The money is used to buy shares in the business, giving it an infusion of capital but still retaining the tax advantages of the 401(k).

Monika Templeman, acting director of employee plans at the IRS, told BusinessWeek that the process “is open to abuse.” If the entrepreneur’s 401(k) funds weren’t rolled over in this fashion, but just withdrawn, the business owner would be subject to income taxes, as well as penalties of 10 percent of early withdrawal if he or she is under age 59 ½.

Templeman says the IRS has seen money used to buy stock whose valuation was questionable or even to buy personal assets such as cars.

The rollover strategy has grown in popularity during the credit crisis; BusinessWeek says some 4,000 people are expected to use the tactic this year. Typically, the transaction involves $100,000 to $200,000 in retirement funds. Financial advisers charge clients an average of $5,000 for the paperwork, plus annual fees of about $1,000 to manage the new 401(k). One financial advisor cited compares the fees favorably to the 15 or 20 percent interest rates banks charge on business loans — that is, if you can get a loan.

With the IRS planning increased scrutiny of such plans, it may be a good idea to review your plan with your advisor and your accountant to make sure it’s not raising any red flags. If you do use 401(k) funds to finance your business, make sure the money is put to good use and don’t use it for any expense for which you can’t make a clear business case.

The IRS website has lots of resources that can help your accountant and advisor clarify the issues. A closer look at the issues with these plans can be found in “Guidelines Regarding Rollovers as Business Startups (ROBS).” This publication is for IRS agents, so it’s pretty dense, but will give you some insights into the issues with the rollover concept.

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Rieva Lesonsky


Rieva Lesonsky Rieva Lesonsky is a staff writer for Small Business Trends covering employment, retail trends and women in business. She is CEO of GrowBiz Media, a media company that helps entrepreneurs start and grow their businesses. Follow her on Google+ and visit her blog, SmallBizDaily, to get the scoop on business trends and sign up for Rieva’s free TrendCast reports.

8 Reactions

  1. That’s a really smart strategy. I hope that the IRS doesn’t come down too hard and cut off a potential funding source for entrepreneurs.

  2. Rieva,

    Thanks for the information. In franchise circles, this is a hotly contested debate.

    I’ve actually had a couple of folks that I’ve helped get into franchises of their own do this.

    Let me add, Rieva, that you know me pretty well; call me skeptical, call me Joel…you know where I’m going with this.

    I am actually ok with someone using a small portion of their 401(K) or IRA to start a business of their own. The paperwork has to be perfect, and they really need to be in a fine financial position for me to be comfortable with the idea.

    If a candidate of mine has let’s say $175,000 socked away in their 401(K), and they were thinking about using $75,000 of it to start a business, I would be uncomfortable with them moving forward.

    A much better scenario would be if a candidate of mine had $500,000 sitting in their 401(K) account, and they wanted to use $100,000 of it towards a business start-up, I would be very comfortable with that.

    Again, the company doing the actual rollover, and all the really enjoyable (I’m assuming it’s enjoyable) paperwork must be experienced and know exactly how to do this.

    The company doing this also needs to be willing to go to the IRS WITH THE CLIENT, if there is an issue in the future.

    And..they need to put that in writing.

    The Franchise King

  3. This strategy is also known as ROBS and is popularized by small business owners “robbing” their 401k plans to finance their businesses.

    This strategy is called ROBS; Rollovers of Business Start-ups.

    Jeff Nabers (CEO of Nabers Group): It

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  5. Joel makes some good points about using a small portion of a 401k. However, I hate to see people risk their retirement savings on a venture where the odds are stacked against them. Too many people will use as much as they can get their hands on and not consider the consequences down the road.

  6. The reall issue with this comes from the DOL asset rules of direct and indirect prohibited transactions. Using the 401(k) to provied 100% of the capital on an operating business may cause the owner to come under scrutiny as “self-dealing” if not done right.

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