Like most entrepreneurs, John Krech doesn't follow conventional wisdom. After 20 years with 3M, he cashed in his 401(k) to launch ePhiphony, a Minneapolis software business that optimizes inventory management for QuickBooks users. But he spent two years developing and testing his product, RightOn Inventory, before he made his break from 3M.
While advisors recommended he leverage his savings with an SBA loan or investor funding, Krech preferred to use his retirement savings instead. Two years later, with Intuit and Microsoft as partners, he thinks he made the right decision.
"I've been offered seven figures for a controlling interest in the business," he says. "I recently calculated that if I'd left my funds invested as they were, I'd be up 35 percent right now. If I accept this equity offer, my return would total over 700 percent."
While Krech's gamble paid off, taking an early withdrawal from your retirement funds is not for the faint of heart. According to Beth McHugh, vice president of market insights for Fidelity Investments, one of the nation's largest retirement fund administrators, such transactions can eat away up to half of your savings.
"Tapping retirement funds should be a last resort," McHugh says. "If you're facing foreclosure or eviction, or you're buried by high-interest credit card debt, you may have no other option. But draining them to start a business is seriously risky."
Even if you borrow against your retirement fund, as some plans allow, those loans typically are due when you leave your job.
David Nilssen and Jeremy Ames founded Guidant Financial to help entrepreneurs use their IRA or 401(k) to buy or start a business without the penalties.
"We found that the Employee Retirement Income Security Act of 1974 (ERISA) and other legal codes allow individuals to self-direct their retirement funds into a variety of investment opportunities, including the purchase of a business or franchise," Nilssen says.
Let's say you have $100,000 in a 401(k). Guidant will help you establish a new corporation with its own self-directed plan. You then direct the plan to buy shares in your new venture. Established in 2003, Nilssen reports the company represents more than 5,000 customers across 50 states and has emerged as a market leader in this niche field. The rate for this kind of service is about $5,000. Ongoing support, record keeping and regulatory compliance run about $100 per month.
Many advisors are skeptical. "I can't begin to describe how complex the rules are in this area, and mistakes can be costly," says Melissa Labant, a technical manager at the American Institute of Certified Public Accountants (AICPA) who staffs the organization's employee benefits tax group.
Perhaps the biggest caution comes from the IRS. Its acronym for the practice, ROBS--rollovers as business startups--says it all. A 2008 memorandum states, "We have examined a number of these plans … and found significant disqualifying operational defects in most."
Guidant's Nilssen welcomed the IRS letter. "For us, it was reassuring to see the IRS issue such a statement--it reinforced the practices we already had in place to keep our clients in compliance," he says. "In reality, what the IRS said is that these transactions can be done properly, but some businesses weren't following the rules."
So, are you worth the risk? Only you can make that call. But before you raid that nest egg to fund your business, be sure to consult a professional or two. Or three.