A ROBS Arrangement stands for ‘Roll-Over as Business Startup’. As the name implies, this is a retirement strategy that allows entrepreneurs to finance a business purchase or acquisition by using their retirement funds in a tax-deferred rollover.
I am commonly asked, “seriously? I can start my own business using my 401(k) funds without penalty?” Yep, you sure can. To do so, you must utilize a ROBS Arrangement.
If you’ve never heard of a ROBS Arrangement, you’ll be surprised to learn that these arrangements became a legal strategy for entrepreneurs as part of the Employee Retirement Income Security Act (ERISA) of 1974. That’s right — this has been around for about a half-century! In 1974, the intent of Congress with the passing of ERISA was to protect private employee retirement pensions from employer mismanagement. ROBS Arrangements were created as part of this legislation, ultimately allowing individuals the right to exercise more control over their investments.
The fundamental intent of a ROBS Arrangement is to be viewed, and used, as a retirement strategy. Many entrepreneurs think of a ROBS Arrangement as a quick way to bootstrap their business startup — but that isn’t exactly how it works. This is because a ROBS Arrangement creates two shareholders who own the company — the entrepreneur and the 401(k) plan. With this unique shareholder dynamic comes limitations and additional compliance rules that the entrepreneur needs to be aware of. Because of this, the 401(k) plan effectively becomes their boss.
So how is this to be viewed as a retirement strategy? Well, first off, keep in mind this is a rollover of funds from your old 401(k)/IRA to your new ROBS 401(k), and then the new ROBS 401(k) buys stock in your business. Immediately after the rollover, If you log into your new ROBS 401(k) account, you’ll see an investment in your businesses stock, which is treated like any other equity position in your retirement plan. As your company balance sheet grows, so does the value of your stock in the 401(k) balance.
For example, an entrepreneur holds $500,000 worth of mutual funds in their IRA. They decide to use $100,000 to finance a business purchase. They decide to rollover the whole balance to their ROBS 401(k) Plan but use only a portion for the ROBS business purchase. They now own the same $400,000 of mutual funds and $100,000 of C-Corporation stock in their ROBS 401(k) plan. The C-Corp stock is in the newly purchased business. This person has effectively converted 20% of their nest-egg into an investment into their own entrepreneurial prowess.
Look at your 401(k)/IRA account — the composition of your investments is probably some hodgepodge of mutual funds, exchange-traded funds, and stocks/bonds. In theory, your retirement portfolio owns a tiny, microscopic sliver of ownership in a large bundle of different businesses. You might be the proud owner of .0000000001% of a popular search engine company everyone uses, but you don’t get to tell management how to run that company! In a ROBS, you are trading away a bundle of diversified investments into a single corporate investment that is owned by your 401(k) plan, which you actively manage as CEO.
Before jumping on board the ROBS train, it’s important to evaluate your business plan similarly to how you would evaluate purchasing another investment security in your retirement account. One great thing about our modern era is that we can pull up the historical performance of our retirement accounts on our phones, tablets, computers, smart toilets, etc. The ROBS entrepreneur needs to really ponder if they can beat their historical market rate of return with their proposed business idea.
For example, an entrepreneur named Andy has finished up a 20-year career and wants to open a donut shop with a popular national franchise brand. Andy’s IRA has a balance of $750,000 and a historical annual rate of return of 16% over 15 years. Andy’s motto is, “go big or go home,” and his portfolio’s high-risk investment choices reflect this. If Andy does nothing, on average his portfolio should grow in theory by $120,000 next year ($750,000 x 16%). That’s not bad at all. Andy would need to beat this — after taxes and his shareholder salary — in order to make his donut shop idea worth the risk of investment. There are many additional considerations to evaluate — and analyzing your portfolio’s historical rate of return is one of the first of many factors to take into consideration when deciding to utilize a ROBS Arrangement.
So, if an entrepreneur’s business is owned by their retirement account, how does this benefit them and their retirement account? Presuming the business is successful, the company stands positioned to return profit in the form of dividends to its shareholders — the 401(k) plan.
Going back to the previous example, Andy’s going to use $250,000 to fund his donut shop. After funding, he will own 5% of the company and his retirement account will own the other 95%. He is effectively forfeiting a hypothetical 16% rate of return — instead believing he can beat this rate of return operating his own business. After taking a reasonable salary of $70,000 per year, Andy’s business performs at a net loss of ($50,000) in year 1, a modest profit of $40,000 in year 2, and a $90,000 profit in year 3.
When compared to the initial $250,000 investment, that makes effective rates of return of -20%,+20%, and +37.5% respective of each annual outcome.
Do you think Andy has made the right choice? Had Andy done nothing, his $250,000 IRA balance would be worth $390,224 at a 16% annual rate of return at the end of year 3 ($250,000 x 1.163). That’s a tax-deferred gain of $140,224. Meanwhile, the business has recouped $80,000 in cumulative profit by the end of year 3, and their C-Corp stock is worth $330,000 ($250,000 x (.8 x 1.2 x 1.375)) before taxes.
However, Andy does have an abundance of working capital on hand at the end of year 3, and after C-Corporation taxes, there is $50,000 in the bank that isn’t needed to keep the company lights on. Andy declares and issues dividends to the shareholders. So, $47,500 gets deposited into his retirement account (95% owner), and $2,500 into his personal account (5% owner).
When we compare how much a taxpayer can save away in an IRA ($6,000 per year) — or a SEP IRA ($58,000 max*) — or a SIMPLE IRA ($13,500) — or your Traditional 401(k) ($19,5000 + employer match up to $58,000 max*), a ROBS Arrangement can operate as a powerful retirement funding vehicle. If Andy’s business continues to grow, so too will the cash available to issue as dividends — back into his retirement account.
*This maximum is the sum of employee deferrals and employer contributions, with rules that vary based on the retirement plan and its participants. This max is also adjusted each year for inflation. Always confirm your contribution limitations with your financial advisor every year.
If an entrepreneur takes a moment to compare their retirement account performance against their proposed business idea, and decides that they can produce a higher rate of return by actively managing their portfolio, then they should go on to read How a ROBS Arrangement Works. Or click here to book your initial consultation with Baum CPA.
This blog and its authors provide this content strictly for informational purposes. No content herein should be misconstrued as financial advice. Everyone’s specific circumstances vary — Always consult with a qualified, licensed financial advisor, legal counsel, and tax professional before venturing into any investment or business activities.