Can You Use Your 401k to Buy a Business?

It is possible to use retirement funds to acquire a business without incurring immediate taxes or penalties. This strategy allows entrepreneurs to leverage their existing retirement savings as a direct investment in a new or existing business venture. The process involves several distinct steps, each requiring careful attention to regulatory guidelines.

Understanding the ROBS Arrangement

A Rollover for Business Start-ups (ROBS) arrangement allows individuals to use funds from their qualified retirement plans to invest in a new or existing business without triggering a taxable distribution or early withdrawal penalties. The Internal Revenue Service (IRS) recognizes ROBS plans as a legal method for business funding, provided they comply with specific regulations.

ROBS arrangements are rooted in the Employee Retirement Income Security Act of 1974 (ERISA) and Internal Revenue Code (IRC). These legal frameworks permit a qualified retirement plan to invest in “Qualified Employer Securities” (QES), which are shares of the sponsoring company. This investment structure allows the retirement funds to be channeled into the business as capital, rather than being treated as a personal withdrawal.

Unlike a direct withdrawal from a retirement account, which typically incurs income taxes and a 10% early withdrawal penalty if the individual is under 59½, a ROBS transaction is designed to be tax-free and penalty-free. The funds are not distributed to the individual but are instead rolled over from an existing eligible retirement account into the newly established 401(k) plan.

Eligible retirement accounts for a ROBS rollover include 401(k)s, traditional IRAs, 403(b)s, 457(b)s, Simplified Employee Pension (SEP) IRAs, and Keogh plans. Funds from Roth IRAs cannot be rolled into a traditional 401(k) plan for a ROBS arrangement. Individuals must be vested in their retirement funds to be eligible for a ROBS rollover.

Setting Up the Necessary Business and Retirement Entities

Establishing the correct legal and retirement framework is a preparatory stage. The initial step involves forming a C-corporation, a specific requirement for a ROBS arrangement, as this corporate structure uniquely allows for the issuance of stock that a 401(k) plan can purchase, known as Qualified Employer Securities.

Forming a C-corporation includes selecting a unique business name and filing articles of incorporation with the relevant state authorities. An Employer Identification Number (EIN) must also be obtained for the new C-corporation from the IRS. Corporate bylaws are developed, and directors are appointed to legally establish the corporation and outline its operational rules.

Following the C-corporation’s formation, a new qualified 401(k) plan must be established for this entity. It must be designed to permit the purchase of employer stock. This involves creating a comprehensive plan document and a trust agreement, outlining the plan’s rules, participant eligibility, and investment provisions. These documents ensure the plan adheres to IRS and Department of Labor (DOL) guidelines for qualified retirement plans.

A separate EIN for the new 401(k) plan is required. This new plan, sponsored by the C-corporation, will serve as the vehicle for holding the rolled-over retirement funds. The plan must include provisions for eligible employees, even if initially the business owner is the only participant.

An independent valuation of the employer stock that the 401(k) plan will acquire is a prerequisite for the funding step. This valuation ensures the stock is purchased at fair market value, a compliance requirement under ERISA and IRS regulations. This independent assessment verifies the transaction is conducted at arm’s length, protecting the retirement plan’s assets from potential self-dealing issues.

Executing the Rollover and Business Purchase

With all necessary entities and plans established, the next phase involves moving funds and acquiring the business. The first action is to roll over funds from the individual’s existing eligible retirement account into the newly established C-corporation’s 401(k) plan.

This rollover is initiated by contacting the administrator of the individual’s previous retirement account. The funds are then transferred directly into the new 401(k) plan’s trust account, which is managed by a designated custodian. This direct transfer mechanism ensures the transaction is classified as a tax-free rollover, avoiding any taxable distribution or early withdrawal penalties.

Once the funds are in the new 401(k) plan, the plan uses these rolled-over assets to purchase stock in the C-corporation. This purchase must occur at the fair market value determined by the independent valuation. The acquired stock represents the retirement plan’s investment, providing the business with its initial capital.

The C-corporation, now capitalized by the 401(k)’s investment in its stock, then uses these funds to acquire the desired business. These funds can be utilized for various legitimate business purposes, including purchasing equipment, inventory, leasing space, or covering operational expenses. This final step completes the financing cycle, enabling the C-corporation to commence or expand its operations.

Maintaining Ongoing Compliance and Avoiding Prohibited Transactions

After the ROBS structure is established and the business is acquired, maintaining ongoing compliance with IRS and Department of Labor (DOL) regulations is important. This adherence safeguards the plan’s tax-deferred status and prevents penalties. Responsibilities include the annual filing of Form 5500, an informational return. This form must be filed electronically with the DOL within seven months after the end of the plan year.

Annual testing is also required to ensure the 401(k) plan does not disproportionately favor highly compensated employees. All transactions between the plan and the C-corporation, or any related parties, must adhere to fair market value rules. This applies to any ongoing purchases, sales, or services to prevent self-dealing and ensure the plan’s assets are protected.

The business owner must receive reasonable compensation for their services to the C-corporation. This salary should be commensurate with the work performed and market rates for similar positions. The 401(k) plan must include provisions for eligible employees, and if the business hires staff, they must be offered participation in the plan according to its terms and ERISA guidelines.

Specific types of transactions are prohibited under ERISA and IRS rules to prevent misuse of plan assets. These include self-dealing, where the plan engages in transactions with a disqualified person. Lending plan assets to the business or using them for personal benefit outside of legitimate business operations are forbidden. Violations of these rules can lead to plan disqualification, resulting in significant taxes and penalties, including excise taxes on prohibited transactions.

An ERISA Fidelity Bond is another ongoing requirement for most ROBS plans, insuring the plan against losses due to fraud or dishonesty by those handling plan funds. The bond amount is 10% of the plan’s assets, up to a maximum of $500,000. Adherence to all operational and reporting requirements is important for maintaining the legal and tax-advantaged status of the ROBS arrangement.