Should You Tap Your 401(k) to Start Your Business?
Monday, June 21, 2010; 12:00 AM
It sounds so easy. In this time of tight credit, you can still finance a new business or franchise by rolling your retirement funds into your new company. You pay no income taxes or early withdrawal penalties, avoid debt and have money available immediately to rent a space, pay a franchise fee, hire employees, buy equipment and pay yourself a salary. And this is all sound, the firms that arrange these rollovers say, because they are "based on long-standing provisions of the Internal Revenue Code."
For thousands of startups, these rollovers are working. Last year, 4,050 businesses--60 percent of them franchises--were launched with retirement rollover money, according to FRANdata, an independent research firm. These new entrepreneurs started ventures that range from data processing companies to flower shops, created more than 60,000 new jobs and added $8.3 billion to the nation's economy. And the lingering recession, says Steve Rosen, CEO of FranNet, a franchise broker firm based in Louisville, Ky., is only making retirement rollovers more attractive.
"Bank credit is tight," Rosen says, "and housing values have dropped so much you can't get a home equity loan. These rollover plans let you invest in yourself instead of investing in the stock market."
Indeed, one of the early adopters, Gary Cote, used $60,000 from his 401(k) in 2005 to start Sunray Technology Ventures, a Palm Desert, Calif., provider of high-speed internet access to hotels. "I didn't want to borrow money or mortgage our home to the hilt," Cote says. "Using my retirement money gave me independence. We've been profitable since 2007 and had revenues of $2.2 million last year. I have 10 employees, and I can't say enough about the scenario that allowed us to provide for all these people."
Although the mechanism for rolling retirement funds into business startups has been available for decades, the practice began in earnest in 2000, when industry founders and former business associates Leonard Fischer, now CEO of BeneTrends Inc. of North Wales, Penn., and Steven Cooper, now CEO of SDCooper Co. of Huntington Beach, Calif., introduced the concept at the annual convention of the International Franchise Association. "We were the hit of the show," Cooper says. Rollovers gained momentum during the early 2000s but fell out of favor during the boom years before the current recession, when credit was easily available.
Today, they are so popular that Rosen estimates 35 percent to 40 percent of all new franchisees recruited through his broker network last year tapped some or all of their retirement funds to get started. So far, an estimated 10,000 small businesses and franchises have been launched nationwide with retirement money.
But if you're considering joining them, you should be aware that retirement rollovers are not as simple as they sound. Obviously, you are putting your nest egg in jeopardy. Less obviously, you are also agreeing to pay a rollover plan provider an annual fee for the life of your business and, some tax experts warn, risking increased scrutiny from the Internal Revenue Service. Although few rollover plans have been questioned until now, the IRS has signaled that it may begin looking at them more closely.
The "long-standing provision" behind these plans is ERISA, the extremely complicated and easy-to-violate Employee Retirement Income Security Act of 1974, which enables employees to be responsible for their own retirement plans.
The three main administrators of rollover plans--SDCooper, BeneTrends and Guidant Financial Group Inc., of Bellevue, Wash.--have tweaked ERISA rules into a neat three-step program. You pay one of them a fee of about $5,000 and it'll do the rest: Move your current 401(k) or IRA (self-directed IRAs are not eligible) into an ERISA profit-sharing plan, which then becomes the retirement plan for your new company. That plan buys up the stock of your new C-corporation. Once the funds have transferred, they become tax-free capital for your business. In essence, you are spending the money on your own corporation instead of for stock of another company, such as General Electric or Goldman Sachs.
"You then open a corporate checking account," Cooper says, "and pay yourself back for whatever you've spent money on and pay our fees." Like the other providers, Cooper charges an annual fee--$800 to $1,440 a year--to file documents required by the IRS to make sure your new "retirement plan" remains safely qualified.
Because maintaining the plans is complicated and expensive, you may think that only people who have no other options for financing a business are using them. But a FRANdata survey of about 500 of BeneTrends' 3,077 active clients shows that many of them are far from desperate. In fact, 89 percent of respondents have college or postgraduate degrees, and 60 percent of them used other sources in addition to retirement money to fund their businesses. Almost half of them were able to finance their investments by using only a portion of their retirement plans, and one-third tapped into only 10 percent to 30 percent of their assets.
But a contingent of CPAs, tax attorneys and pension experts, including Stephen Dobrow, immediate past president of the American Society of Pension Professionals and Actuaries and president of Primark Benefits in San Francisco, is concerned that the IRS is about to crack down on both rollover plan promoters and their clients.