I was recently contacted by a potential client that asked about using a rollover into business startup (ROBS) to fund his new business. I had heard of a ROBS, but I didn’t know much about how it worked so I decided to do some research.

A ROBS account (a very unfortunate acronym, in my opinion) allows a new business owner to use his or her retirement funds to start their new business. That means that they can use money from their 401(k) or traditional IRA without paying taxes or penalties so long as the money is used correctly for the new business.

How a ROBS Works

First, the entrepreneur must form a C-corp. Unfortunately, a C-corp is the only permitted business entity. C-corps tend to be more complicated to maintain, and an S-corp or an LLC would generally have tax benefits to the owner.

The entrepreneur then sets up a retirement account for the new business. This could be a traditional 401(k) plan or a profit-sharing plan. Then the owner transfer funds from his or her personal retirement account to the business retirement account. There are no penalties or taxes paid for this transfer. That’s the point of the ROBS. Using those funds, the company retirement account buys shares from the company. Those funds are then available as cash for the company.

Requirements to form a ROBS

The business owner must have an eligible retirement account. Most accounts are eligible except for Roth IRA’s and Roth 401(k)’s. The owner must also have at least $50,000 in retirement funds. This is not technically a rule, but the costs of forming and funding a ROBS can be steep and anything less than $50,000 won’t make sense.

Lastly, the business owner must be a legitimate employee of the business. This usually means that they must work at least 1,000 hours a year. Owners must be careful not to overpay themselves because that would get them into trouble with the IRS and Department of Labor (DOL).

The funds must be used for the business. They cannot be used in any way for personal use. This makes sense because if the owner could use the money for personal gain, he or she would essentially be taking the money out of the retirement accounts without paying taxes or penalties. Obviously, the IRS and DOL would prohibit that kind of use.

ROBS Costs

There is usually a high upfront fee required by providers. The fee is usually around $5,000. The ongoing costs can be as high as $150 per month to maintain the ROBS.

There are some other costs associated with a ROBS. Employees are allowed to invest in the exact same way that the owner does, meaning they can invest in the retirement plan and use those funds to buy shares of the company. The owner is obligated to educate his or her employees about these options.

(“Rollover for Business Startups (ROBS): The Ultimate Guide”, Dennis Shirshikov, “Rollovers as Business Startups (ROBS): What You Need to Know”, Steve Nicastro)

ROBS: good idea or bad?

I think whether a ROBS works for an individual is based greatly on who that individual is and what they plan to do with the money.

The main benefit of a ROBS is that you can fund your startup with your own money. Therefore, you have no investors and no debt costs. If your business does well, your retirement funds can increase greatly.

The main problem is the risk of losing your retirement funds. If you’re comfortable with risk, then you might feel fine putting your funds on the line. If you have a lot of retirement funds, you may not be risking your entire retirement, and if you’re young, you have plenty of time to build up your retirement accounts before you actually retire.

The nature of the business matters, too. If you’re investing in a franchise or something with a proven model, the risk is a lot lower than starting a brand-new business. Most new businesses fail or aren’t very profitable. Picking an industry, you know and a business model with a good track record will help mitigate that risk.

The last risk is the fact that you have to make the retirement plan available to your employees. For most small businesses this is not a problem, but I could see a situation where the ownership shares could get a bit diluted. The owner would need to keep an eye on this in certain circumstances.

Bottom line is that the ROBS may work for the right person in the right business. Rules need to be followed, but if you handle everything correctly, this could be a low-cost way to fund a new startup.