Most of us have been living with a thought that our retirement money (401K, SAR-SEP, etc) is better off being invested in something other than our own business. Therefore, we have no choice but leave the funds with a financial advisor or CPA because the rules for retirement funds are complex. We understand that the advisors themselves are heavily regulated and therefore invest our funds mostly in public stocks or bonds. Have you asked yourself where your funds are best invested? If you have, it is likely you’ve come to the conclusion that if you could invest your retirement money in your own business, you would.
Not many people do this, but there are ways to use your 401k, or other qualified retirement plans in your own business without being hit with taxes and early withdrawal penalties. Most financial advisors will steer their customers away from these types of solutions, primarily with the argument that small businesses are risky and you want to diversify. However, if I am an entrepreneur, I am willing to take risks and if the money is in my own company I can make diversifications myself. In addition, I don’t have to invest all of my retirement funds in my business. Finally, how safe has real estate and stock investments been over the last couple of years? To make things worse many investments were made in financial instruments that were destined to fail and by advisors who set their personal wealth before that of their clients. Prior to the housing market’s collapse entrepreneurs typically took out a second mortgage on their homes to finance their business venture. As property values have dwindled across the country so has the ability to raise capital for the small business owner. Clearly the retirement accounts are an untapped source. It comes in handy for all small business owners but particularly for those in the startup mode or those making substantial investments.
There are two ways to go (one less complex than the other). The first solution is to establish a 401k plan in your business and transfer the money from your original retirement plan to the 401k plan. The funds in the 401k plan can then be borrowed for business purposes. However, there are some restrictions. The loans are limited to $50,000 and cannot be more than 50% of the value of the 401k plan. Furthermore, the loan has to be amortized over five years and interest has to be paid in the range of 1%-2% above prime. Depending on how large your business is, $50,000 may or may not be a substantial amount, but if you translate it into an amount that you now can use for buying and selling containers, it can be a meaningful addition to the bottom line.
Here is an ideal example. If you buy containers for $50,000 and can resell them with a 20% markup, then you have made $10,000. If we simplify things and say that you pay cash to your vendor and your customer pays cash to you but it takes 30 days from when you buy the containers until they are sold then you can turn your inventory 12 times per year. That’s an addition to the bottom line of $120,000 less interest.
Funds available from retirement accounts $50000
Sales of containers
Investment in containers
Proceeds from sales
Interest expense at 5%
Profit from use of $50,000 over 12 months
Most likely, establishing a 401k and using the funds this way beats the return in your traditional retirement account. As long as you use the funds for activities that generate immediate cash, this solution works well. If you use the money for longer term investments then you have to think about the net cash flow after taxes, interest and amortization. If the loans are not paid promptly, the unpaid portion is subject to income tax and penalties if the owner is younger than 59 ½ years old.
The second method is called ROBS, Roll Over as Business Start-ups. This arrangement provides a business owner with the ability to convert retirement accounts into business capital by using the rollover process. By creating a new corporation that sponsors a new retirement plan, the individual can rollover funds from a prior retirement account into the new plan. Then, through an exchange of corporate stock for the rollover money, the owner receives instant business capital. The retirement plan owns all the stock, for the benefit of the owner, and the business receives needed cash. So the plan has created a new owner of the corporation, the retirement account, whose beneficiary is the owner of the retirement account. The benefit with this plan is that all funds are made available, there are no restrictions on amounts nor is there a limit on how long the funds can be used. However, there are several challenges with the ROBS plan. First of all, to establish the stock price the value of the business must be confirmed by an independent appraiser. Secondly, IRS is unclear on a number of issues concerning the ROBS plan. One important concern is that the distribution restrictions normally associated with taking money out of a retirement plan is circumvented, and the capital (which includes previously untaxed income) is deferred while the owner of the retirement account benefits from the use of the capital. Another concern is that the new retirement account is only beneficial for the business owner and doesn’t include the employees of the new company (which it technically the purpose of a retirement plan). Most owners don’t want their employees to have stock in their company and therefore they close the retirement fund once it has been set up and the capital invested. In addition there are a number of companies promoting their service of helping to set up the ROBS. Note; if their fees are paid with funds from the retirement account the fund may be in breach of IRS regulations.
So as we are going into better times and you need to think about where to get more capital, your retirement accounts may be a source. As of now, you still can’t go to the bank, but do you want to take the risk of using your retirement funds or some of it? If you are confident in your business it seems to make sense especially if you don’t have use all your retirement savings. Be aware that if using ROBS, the IRS rulings aren’t clear and therein lays a non commercial risk. However, people have been setting up ROBS and it has provided them with the capital they needed to grow their businesses. Finally, the tax rules are complex and how they apply varies from one situation to another therefore be sure to have good tax advice before you establish any of these programs.
Want to know more? Look at these two websites.