Whether starting your own business or investing in someone else’s, the outcome can be a boon to your financial growth and long-term security.

Many people are tempted to tap into their 401(k) or IRA, but are surprised to learn that there are several rules and regulations that must be followed closely.

Rollover Business Startups (ROBS) and self-directed IRAs (SDIRAs) are two of the most popular tools for funding business startups, though each serves different purposes. Understanding the differences between a ROBS 401(k) and an SDIRA can help you determine the best option for your business goals.

Rollover for Business Startups (ROBS) Overview

ROBS is a funding structure that enables you to utilize your retirement funds, such as those in a 401(k) or IRA, to purchase or establish a business without incurring a loan or paying early withdrawal penalties.

To leverage this strategy, you set up a C corporation that sponsors a new 401(k) plan. Then, as the name suggests, you roll your existing retirement funds into the new 401(k).

Once established, the ROBS 401(k) can buy stock in your C corp, giving your business the capital necessary to grow and operate.

The ROBS approach allows you to tap into your retirement funds to avoid accruing debt as you open and run your business. However, it can also lead to significant financial risk, as it depletes your retirement account for the near future, and future growth will depend, in part, on your company’s success.

Self-Directed IRA (SDIRA) Overview

A self-directed IRA is a retirement account that allows you to invest in a wide range of alternative assets that are prohibited in standard IRA accounts. These assets include real estate, precious metals, private equity, and LLCs.

While you can leverage ROBS to invest in your own business, that’s typically not possible with an SDIRA. Investments held in an SDIRA must be passive, meaning you can’t directly benefit from them.

As such, you can’t use SDIRA funds to fund the purchase of a business you intend to own or otherwise take an active role in. The same applies to any company owned by a disqualified person, such as a spouse, child, grandchild, parent, or account custodian.

Nevertheless, a self-directed IRA can be set up to fund or purchase a business that will profit the self-directed IRA, but cannot benefit the account holder personally. This approach comes with a laundry list of prohibited transactions, barring you from doing business with yourself or any disqualified persons.

To set up an SDIRA, you need an IRS-approved custodian specializing in self-directed accounts. Once set up, you can fund the account and invest in assets as you see fit and as aligned with IRS guidelines.

Key Differences Between ROBS and Self-Directed IRAs

Ownership and Control of Funds

With a ROBS, you can invest directly in a business you control and actively operate with your retirement funds. As such, you can consider yourself an employee of the business and draw a salary.

SDIRAs allow you to invest in a business, but you can’t personally benefit from, work for or otherwise actively participate in the business operations in your IRA. Doing so would be considered “self-dealing” and is strictly prohibited by the IRS.

In short, a ROBS can be used to open and operate a business. An SDIRA is only for the benefit of the account, not the account holder personally.

Investment Restrictions and IRS Regulations

ROBS accounts are 401(k)s structured through a C corporation. To avoid early withdrawal penalties, you must roll funds from your existing retirement account into the ROBS 401(k). Once in that account, the funds can be used to purchase stock in the new business, thus generating capital for your business from your retirement account.

When you open an SDIRA, you are free to invest in a range of alternative investments, including C Corps. However, you cannot invest in a business you or a disqualified individual actively manages or benefits from.

Tax Implications and Reporting Requirements

When structured correctly, a ROBS 401(k) offers a penalty-free way to fund your business through stock purchases, but several filing and compliance considerations must be considered.

When leveraging a ROBS 401(k), you must meet compliance standards for the IRS and the Department of Labor (DOL). Requirements include, but are not limited to, filing IRS Form 5500 and offering eligible employees the opportunity to participate in the retirement plan.

If you’re using a 401(k) to fund a business startup,  it’s vital you work with an experienced financial advisor or tax expert who can help you navigate requirements and ensure compliance.

SDIRA tax implications and requirements are aligned with those for standard IRAs, meaning they will vary based on the type of SDIRA you have: Traditional or Roth. For instance, if you have a Traditional IRA and are 73 years or older, you must take annual required minimum distributions (RMDs) and report those each tax year.

Beyond that, tax implications may also include filing Form 5498 and/or Form 990-T if an investment generates unrelated business taxable income. This is more likely to occur if you invest in an LLC that operates an active business, like a restaurant, generating regular business income rather than passive income. For example, if the LLC earns profits from daily restaurant sales, those earnings could trigger Unrelated Business Income Tax within the IRA.

Risks and Compliance Considerations

When you use 401(k) funds to open a business, you risk a substantial loss of retirement funds if your business fails. In addition, failure to follow IRS and DOL requirements and compliance standards can yield tax penalties, fines, and audits.

In terms of business investments, if you have an SDIRA, your primary risks come from investing in prohibited transactions, which can lead to penalties. Further, if the issue is unresolved, your plan can be disqualified, which means you’ll lose IRA status.

How to Choose the Right Option for Your Business

Generally, if your goal is to fund your own business, a ROBS 401(k) is the right choice. However, these questions can help you further determine which approach is best:

• Do you want to be actively involved in the business? Choose ROBS if you want to run or start a business using your retirement funds.
• Are you looking to invest passively? An SDIRA is often the right choice if you want to passively invest in startups or other business ventures without managing the business. Remember that IRS rules also prohibit you from investing in businesses held by disqualified persons.
• Do you have the risk tolerance to use retirement savings for business ventures? Both options carry risk, but leveraging 401(k) funds to start a business can pose unique risks.  It’s essential to consult with a financial advisor or tax professional before proceeding.
• Do you understand the compliance requirements? ROBS requires adherence to specific IRS and DOL guidelines. SDIRAs require knowledge of prohibited transactions.

Funding a business using a ROBS or SDIRA strategy can be a great way to bypass the need for expensive, high-interest loans. However, your ability to actively manage or passively invest in the business will depend on which strategy you choose.

FAQs

What is the main difference between a ROBS and a Self-Directed IRA?

A ROBS is a way to leverage your 401(k) or IRA to fund a business you intend to be actively involved in. An SDIRA allows you to invest in a business passively — you cannot own or actively participate in the business, nor can a disqualified person.

Can I use a ROBS to start any type of business?

In general, you can use a ROBS to start any type of business that is structured as a C-Corp, including startups and established businesses.

What are the risks of using retirement funds to finance a business?

The most significant risk of using retirement funds to finance a business is that it jeopardizes your future. Once funds are removed from the account and used to fund the business, those funds no longer earn interest or otherwise grow your retirement. If the company fails, your retirement fund may not rebound.

Are there any penalties for using a ROBS or Self-Directed IRA?

As long as you use a ROBS to fund a properly structured C-Corp and maintain compliance with IRS and DOL requirements, there are no penalties for using a ROBS to fund a business.

You cannot use an SDIRA to fund a business in which you or a disqualified person plans to actively participate. If you do, the investment is considered self-dealing, which the IRS prohibits. If you don’t comply with IRS rules, your SDIRA may be subject to penalties or lose its qualified status.