Shortage of capital is a frequent problem that plagues many small business owners. Whether it is the need to raise money to expand the business, take advantage of an investment opportunity or simply meet payroll and other expenses in a down cycle, small businesses are often desperate for an influx of capital.
Capital crunch time and tight or negative cash flows are hurdles many small businesses will at one time or another have to overcome to stay in the race. Many small business owners have personal retirement accounts, which they either funded while working for someone else or on their own, before or after starting their new company. As tempting as it is to draw upon those accounts, it is wise to look elsewhere. For those who have no other option however, tapping their Keogh plan, IRA or other retirement account may be their last option. It is a risk, but if it is calculated, it can work. It can be the life raft to save a business, but there are procedures that need to be followed and consequences that cannot be ignored. If you are going to risk your retirement funds, you should also be sure you can weather the consequences if it doesn't work out.
Rollovers as Business Startups (ROBS)
The rather unfortunate acronym for Rollovers as Business Startups is both a bit of tongue-in-cheek wordplay and a warning. Using money in a retirement account to start a business, in one sense, does indeed rob that account, but there are ways to do it properly and without incurring the hefty tax penalties that drawing money from such an account would normally incur. Although risky, the IRS recognizes the ROBS mechanism as a legitimate option for funding a business. It must be done very carefully however, for the IRS is wary of those who use such procedures as schemes to avoid taxes, as this Department of the Treasury memo notes.
There are experienced ROBS consultants who can, and should, be hired to help guide a budding small business owner through the legal and levy minefields to ensure regulations are adhered to. These steps involve setting up a C corporation, establishing a 401(k) plan for the company, and then rolling over your personal retirement savings into that corporate 401(k). The newly established corporate 401(k) plan is used to buy stock in the business, thus funding it. Essentially, the plan becomes an owner of the business. As this can be a complicated and expensive process, be sure not to leap before you look, and rather let a qualified ROBS provider help you look.
Cashing in or Borrowing Against Retirement Accounts
Borrowing against a retirement account to start or fund a business may expose a small business owner to significant tax penalties, unless he or she can quickly put that money back into the retirement account within 60 days. Thus, for a very short-term capital loan, borrowing against your retirement account can be a way of getting an interest-free loan, and without having to worry about qualifying for such a loan — unless you plan to turn yourself down. If you cannot or do not repay the loan however, it will count as income, so unless you have significant tax deductions to offset that income, you are sure to incur additional tax liabilities. Furthermore, if you are under the age of 59 ½, there is an additional 10 percent penalty if you do not pay it back in 60 days.
Retirement Account Loans
Some retirement plans, notably those set up by employers, do allow plan members to take out loans against their accounts. These plans are usually limited in contributions made by the employee, as opposed to contributions made by the employer. Every plan is unique however, and before borrowing against such an account, whoever manages the plan must be consulted. The IRS, moreover, limits borrowing from such accounts, notably 401(k) accounts, to half of your vested balance or a maximum of $50,000. Such loans must be paid back within five years and with interest. The interest varies from plan to plan, and are at the discretion of the plan manager.
This article was written by Mark G. McLaughlin for Small Business Pulse