There are many retirement asset-funded investment and business schemes out there that run the
gamut from taking loans to “rollover as business startup” (ROBS) plans. They have been around
for many years and while the answer is typically yes, you can, they are generally a bad idea and I
discourage most would-be investors due to the legal and financial liability involved.
These plans are concocted by financial advisers, brokers, realtors, banks, etc. as a way to access
retirement funds, which are typically invested in mutual funds, CDs, stocks, bonds, etc. While
these investments may not be perfect or without their own risks, it is often easier to understand
the risks involved in buying mutual fund shares than a new business, especially if you do not
have experience with valuations, operating a business and other important business owner skills
and knowledge. The risk to your retirement savings is obvious: if your investment venture falls
flat and you lose money not only will your retirement savings evaporate but because retirement
accounts are tax-deferred you cannot deduct losses against your income.
There are two very common investment types these schemes promote: property investing and
new business ventures. There are several ways that you can access your retirement assets to
finance these ventures and I’ll discuss those in kind. Before getting further into the discussion, it
is important to note that as a financial matter people find themselves in very different situations
and something that may be a good idea for some people can be a terrible idea for others. The
information below, as it relates to the financial aspects of these schemes, is intended to be
general and should you decide to further explore these investment schemes you should definitely
consult with an accountant or certified financial planner (CFP) competent to advise you on your
given situation. You may also need to speak with a lawyer experienced in handling business
affairs or real estate law.
The property investing schemes were very popular during the housing boom in the mid-2000s.
Plans were cast about to help people use their 401ks and IRAs to buy their principal home, or
homestead, as well as vacation homes, timeshares and investment properties, either to rent or
flip. Sometimes these strategies worked out well for people but there were many people who
bought investment properties only to find they could not rent them out or they could not find a
buyer when they tried to flip the house.
Some of the more permanent options include forming corporations that own the properties and
then the retirement money is rolled into an IRA where the funds become free from the limited
investment options of the 401k (unless you own a business where you could make that an option
in your own plan) and you can hold stock for your operating company that owns the underlying
properties. These accounts created some real problems for people. If the property would not sell
or rent out, that was lost income that cannot be deducted (from the personal taxes). There are
also concerns over where money for repairs, insurance and taxes come from. When tax-deferred
and after-tax money mingle by the owner it creates complicated tax situations that can result in
as little as paying extra taxes or penalties to as much as potentially losing the tax-deferred status
of the assets.
Less permanent options saw people taking 401k loans or withdrawals from IRAs with the intent
of returning the money in sixty days as a “rollover”. A plausible idea if you planned on flipping
the house within a very short time period but as happened as the housing market cooled, those
houses did not sell. If you took a loan, you had to pay through your salary plus pay the costs of
keeping a house you cannot sell, taking a double hit on your income. If you took the IRA
withdrawal, you likely saw those funds become taxable and possibly incur the 10% penalty.
Business ventures tend to only follow more permanent retirement-based financing because most
people do not flip businesses and rarely have the opportunity to keep a 401k loan active when
they leave to form their own business. Rather, people tend to start new businesses, buy existing
businesses or buy franchises as either their full time employment or as a side venture. Franchise-
based businesses are especially keen on promoting these arrangements, especially ROBS
discussed below. The obvious concern here is the business risk. Many new businesses and
franchises fail and end up bankrupt. The result is again, losing that retirement money and having
no way to deduct the loss. An additional concern is tying your money up in a single venture
means you are not diversified which increases the damage caused by a single bad investment
(not that diversification is without its pros and cons).
One common technique, like property investing, is to roll your money into an IRA, form the
corporation and then buy the shares of your corporation with your IRA funds. This can create a
tricky tax situation and if you go this route, you should seriously consider hiring a qualified
accountant to help you navigate the taxes. Like property investing, you can create serious tax
problems when you mix taxable and tax-deferred funding in a business.
A bizarre and generally dangerous idea is the rollover as business start up (ROBS) technique. In
this scheme, you use your business’s 401k plan to finance the company to a slightly different
effect than funding through an IRA. In a ROBS strategy you form your corporation and the first
step the business takes is to create a 401k plan. You then roll your retirement funds into the 401k
plan and make the investment available shares of the corporation. You then “buy” the shares
which transfers your retirement money to corporate assets while the shares are held in the plan.
The benefit of this strategy is that the business is not a tax-deferred vehicle so you avoid the tax
pitfalls of investing in the IRA. Plus, your 401k assets cannot be touched by creditors in
bankruptcy (although you may not have anything worth taking beyond the worthless shares of
your bankrupt company).
However appealing it may sound, it has serious problems. In addition to the business risk, you
have to deal with running a 401k plan which is not as easy as you might think, especially to get a
ROBS off the ground. To invest in the 401k without executing prohibited transactions you have
to very carefully execute several steps. Then you have to complete various tax forms,
disclosures, etc. to keep the plan running viably. The effect of improperly operating the 401k can
run anywhere from penalties to a cool 110% penalty, which effectively means you owe the IRS
all your 401k money plus 10%. Ouch. Of course, you can pay for an administrator to assist you
but that will be expensive and your business may not have the finances to support it.
Unsurprisingly, the IRS and DOL pay careful attention to very small 401k plans because
business owners, especially when they are the only plan participant, tend to abuse the plan to
avoid paying owed taxes and get themselves in hot water.
As you can see, there are many financial and legal concerns involved in these schemes. Rather
than take the likely unqualified advice of the person hawking this idea to you, you should
carefully discuss these concerns with legal, tax and financial planning specialists who can help
provide you with accurate information relevant to your situation.