Using a 401(k) to invest in a business
Mark Schottland's 401(k) took a beating in the market crash of 2008, and its value plunged 35 percent, to $65,000. But rather than go into a mattress fund, the Nashville resident decided to invest in himself.
Schottland used what was left of his nest egg at the end of that year to buy the Nashville franchise for Dogtopia, a dog day care and boarding business that had 27 locations nationwide at the end of last year.
To do that, he took advantage of a little-known transaction called rollover-as-business-start-up (with the confidence-inspiring acronym of ROBS). That allowed Schottland, then in his mid-30s, to sidestep the typical income taxes and 10 percent penalty that hit those under the age of 59½ who withdraw money from tax-deferred retirement plans.
The ROBS loophole is complex: It allows would-be entrepreneurs to roll over their existing 401(k) or individual retirement account to a plan set up within a new company, and then has that 401(k) purchase stock in the company.
"I decided I'd rather invest my retirement money in my own abilities than in the stock market," Schottland says. "There's a lot of risk in investing in your own business, but at least you have control over your own destiny. In the stock market, you just don't."
A BUSINESS LOAN ALTERNATIVE. Proponents say that ROBS offers a debt-free means of financing a start-up or buying a business -- especially at a time when business loans are hard to come by. But critics say the deals are too risky and tax compliance is too complex. The Internal Revenue Service is not a fan.
ROBS supporters note the rolled-over funds can still ultimately be used for retirement and are taxed on withdrawal. When ROBS-financed enterprises are successful, profits can be used to buy stock back from the 401(k) gradually, reducing the plan's exposure to the business and diversifying the investment mix.
That's possible, of course, only if the business succeeds. Only half of new businesses survive to their fifth year, according to the U.S. Bureau of Labor Statistics; the 10-year survival rate is about one-third.
Should the tax benefits of a 401(k) or IRA be used for something as risky as a business start-up? Advocates point to exemptions in the Employee Retirement Income Security Act of 1974 (ERISA) that permit many 401(k) plans to offer employer stock as an investment option to participants. The IRS has questioned ROBS in the past, but it issued a ruling in February acknowledging that they can be done legally when the transactions fit within the ERISA exemptions.
Guidant Financial, a company that helps entrepreneurs execute ROBS and advised Schottland on the Dogtopia deal, says more than 80 percent of its clients are still in business after five years, most likely because the ROBS-generated equity reduces the amount of debt required to launch their businesses.
Guidant chief executive David Nilssen adds that most clients have significant business experience and are affluent enough to take a risk. Half have owned a business before, and most have senior-level managerial experience.
NOT FOR EVERYONE. Tom Kolb, an attorney who specializes in advising workplace plan sponsors and also advises clients executing ROBS transactions, says he doesn't encourage every client to jump into a ROBS arrangement. He says he thinks ROBS make sense only when other sources of capital -- including bank loans -- aren't available. He cautions that ROBS deals come with a number of risks and burdens, including tax code compliance, tax planning and the expense of operating a qualified retirement plan that must comply with tax and ERISA rules.
"There are a lot of traps for the unwary," he says. "All other things being equal, you wouldn't put such a large proportion of your wealth into one investment. But this approach has advantages for someone who couldn't otherwise start a business."