Skip Sheppard took a bet on himself in 2011. The 59-year-old used $200,000 from his retirement accounts to buy a business.
Using a financing option called a rollover for business startups, or a ROBS, he reopened and expanded Three Lantern Marine and Fishing, turning the Gloucester, Massachusetts, fishing supply store with $275,000 in sales into a $3 million business.
"We were very fortunate with the location and the type of business we are in, and the market was rebounding," Sheppard says.
But not every business will succeed, and a ROBS carries one particularly notable risk: You could jeopardize your retirement. While this type of financing can provide you with money to fund your business, the complex transaction doesn't make sense for everyone. Here's what you need to know about the process, including the potential benefits and possible downsides.
How does a ROBS work?
In this type of transaction, funds from eligible retirement accounts, including a 401(k) or a traditional individual retirement account, are rolled over in most cases with the help of an attorney or a ROBS provider and invested in a new business or franchise, or used to buy or put money into an existing business. Here's what happens.
- A C corporation -- a corporate structure that allows shareholders -- is formed. Then a new 401(k) plan is created for the business.
- The owner's existing retirement accounts are rolled into the new 401(k) plan. Most retirement accounts qualify.
- The rolled-over funds are used to purchase company stock in the C corporation. The proceeds from the sale of stock is the cash that's invested in the business.
It's an alternative way to finance your business. Lenders typically require strong personal credit, positive cash flow and collateral for loan approval. A Rollover for Business Startups is an option for an entrepreneur who has built up retirement savings but who may not otherwise qualify for a business loan.
You won't take on debt. A ROBS isn't a loan. You don't have to worry about monthly repayments, incurring high interest fees or defaulting. You can reinvest more of your profits into the business, which is critical for newer businesses.
You won't pay penalties or taxes. Withdraw funds directly from a 401(k) or IRA before turning 59½, and you'll get hit with a 10% early withdrawal penalty and face a distribution tax. You avoid those with a ROBS.
Your retirement is at risk. Despite the potential payoff, this is a significant downside. If your business fails, say goodbye to your retirement nest egg.
"Some of our clients' businesses fail and they lose their money, 100% of it," says Frank Selden, an attorney based in Bothell, Washington, who helps clients set up Rollovers for Business Startups.
You'll lose out on retirement-savings gains. Since you are committing your retirement nest egg to finance a business, you'll lose the potential gains from a rising stock market, the tax-deferred savings of 401(k) and IRAs, and the power of compounding as investments grow over a long period time.
You must operate as a C corporation. A C corporation is a more common business structure for larger companies. The tax implications differ from a sole proprietorship and a limited liability company, so it may not be a good fit for your business.
You'll pay costly fees. Benetrends Financial and Guidant Financial, two ROBS providers, charge $4,995, plus a monthly 401(k) administration fee of $139, which includes assistance with filing IRS forms. These fees cannot be paid using the proceeds of the transaction.
Sheppard, the business owner, spent time researching a ROBS and consulted with his accountant, ultimately deciding to use Guidant for his transaction.
The risk of an IRS audit could be greater. You may face increased scrutiny from the IRS after completing a ROBS, says Barbara Weltman, author of J.K. Lasser's Small Business Taxes 2017.
Any mistakes made during the transaction can wind up disqualifying the ROBS plan, which could result in IRS penalties and make the transaction taxable, Weltman says.
However, only a third of 1 percent of its ROBS clients faced an audit last year, according to Guidant CEO David Nilssen.
Does a ROBS make sense for you? Before tapping your retirement funds, find out if the potential benefits of a ROBS outweigh the risks, costs and legal requirements. Talk to an attorney or tax expert for advice. Compare other financing options, including personal savings, bootstrapping or finding partners.
"This is really for people willing to take a risk on themselves," Selden says.
Steve Nicastro is a staff writer at NerdWallet, a personal finance website. Email: Steven.N@nerdwallet.com. Twitter: @StevenNicastro. This article was written by NerdWallet and was originally published by USA Today.