Thinking of starting your own business? Here's a little-known way of funding it
A Rollover as Business Startup, or ROBS, lets business owners use money from a retirement account without any early withdrawal penalties or taxes for their business. Here are the pros and cons of choosing this route.
—If you’re thinking about starting a business, one of your first major decisions will be choosing where to get funding. Many new business owners will turn to a bank or alternative lender, such as OnDeck, to get funding. Others may borrow money from family and friends or charge expenses to a credit card. However, there is one method that has been steadily gaining popularity in recent years: a Rollover as Business Startup, or ROBS.
What is a ROBS?
A ROBS lets business owners use money from a retirement account, typically a 401(k), without any early withdrawal penalties or taxes for their business. To set up a ROBS, the business owner must roll over funds from his existing retirement account into a new employee retirement plan set up by his or her business. Then, as the only participant in his company’s plan, he (or she) can then use the funds in this company’s plan to purchase stock in the company. And the money for the stock purchase is redeployed for business purposes.
A ROBS can be tricky to understand and set up, but many business owners use a ROBS as a debt-free way to start a business. Here are some more reasons why you should consider a ROBS:
It’s not a loan: Using a ROBS means you don’t have to take out a small business loan, so there is no debt or loan repayment. That means there is no interest to pay, or impact on your credit score.
Most retirement plans qualify: Most people use a 401(k) to set up a ROBS, but other plans, such as 403(b), traditional IRAs and SEP IRAs, also qualify (Roth IRAs are, unfortunately, ineligible).
The funds are tax-free: ROBS are tax-friendly in two ways. First, you get to roll over funds from an existing retirement account without paying any penalties or taxes. Second, once the company’s plan is set up and you’ve purchased stock in the company, you can use that money tax-free for the business.
While a ROBS may have its benefits, it is not without drawbacks. Below are some the main reasons why you may want to reconsider using a ROBS to start a business:
You could lose your retirement money: When you use a ROBS for your business, you are risking your retirement funds. If your business fails, you could be losing your entire retirement nest egg.
A ROBS is complex to set up: There are a lot of rules and regulations for setting up a ROBS, and many business owners opt to pay a third party, such as Guidant, to set up and administer the ROBS.
You may be audited by the IRS: Due to the complexity of a ROBS, you may be more likely to be audited by the IRS. If the IRS finds that your ROBS transaction violated any rules, you could pay penalties and taxes.
Your business must be a C Corporation: A ROBS can only be used for businesses that are registered as C Corporations, so businesses registered as LLCs, partnerships or sole proprietorships are not eligible.
A ROBS can be a good vehicle for starting a business, but it’s not ideal in many cases. If you don’t have a lot in the way of retirement savings, it’s better to consider alternate methods of funding. Even if you’ve amassed a decent-sized nest egg, you should evaluate whether starting your business is worth risking any of your retirement money.
This story originally appeared on ValuePenguin.