Mark Pestronk
Mark Pestronk

Q: I have been working as an employee for a big company for many years and have accumulated a lot of money in my 401(k) account. Now I want to start a small, high-end tour operator business, but once I pay the income taxes and penalties on withdrawals from the 401(k), there will not be enough money left to start the business. Also, I have a friend that has a large IRA and wants to use the money to buy an existing tour operation. Is there a way that he and I can avoid paying those taxes?

A: Yes; you can both do what is called a Rollover for Business Startups, or ROBS, which is a multistep procedure that allows you to defer any taxes that you would otherwise owe on the amounts taken out of your 401(k) plan or IRA.

A ROBS is complicated and full of rules imposed by the IRS on what you are allowed to do with the money. They also require a plan administrator, just like a 401(k) does.

Here's how it would work: First, you set up a new corporation. Second, using a plan administrator, you set up a new 401(k) plan for the corporation. Third, you roll the money from your existing 401(k) plan into the new one. Fourth, the new 401(k) plan buys the stock of the new corporation, putting the money into the business. Fifth, the business starts up using that money.

You can also buy an existing business, as long as you use the money that is in the new corporation to buy the stock or assets of the seller's business.

It is theoretically possible to take these steps all by yourself, and it is even possible to be your own administrator of the 401(k) plan instead of using a third-party administrator like a CPA firm or trust company. However, all the experts warn against doing it yourself because of the IRS rules governing what you are allowed to do with the money.

Your best bet is to have an experienced third party handle the rollover and then act as the plan administrator. ROBS administrators, which you can find by Googling "find ROBS administrators," are highly specialized and charge a fee to do the initial setup and a monthly fee for plan administration.

The IRS restricts what you can do with the money in the corporation. You cannot use it to pay any of your personal expenses or pay yourself a higher-than-normal salary. You cannot use business property for personal purposes; so, for example, you could not use a company car as your family car.

Since your new business will have a 401(k) plan, you have to allow employees who qualify to participate if they wish. This makes them indirectly your co-owners in the operation of the business.

Your corporation must remain a C corporation, which means that it will pay income taxes on profits and then distribute taxable dividends taxed to you, resulting in two layers of taxation. You cannot convert to an S corporation or an LLC, which automatically pass through all profits and losses directly to the owners.

All the experts say a ROBS is "risky" because running afoul of the IRS rules could result in major penalties and because most startup businesses fail, which would wipe out your entire retirement savings. If you are a success, it may be difficult to take advantage of all the money you make.

As with all tax-savings strategies, there are lots of exceptions to the general rules stated here. That's why you need to consult a knowledgeable tax attorney or CPA before doing a ROBS. 

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