By Andy Ives, CFP®, AIF®
IRA Analyst

Ivan is an inventor at heart, but he is stuck in an office at a job he does not particularly care for. Ivan constantly daydreams about starting his own company and improving everyday life with his inventions. For 20 years Ivan funds his 401(k) and tinkers with his creations when he gets home from work.

With a burst of inspiration, Ivan invents the widget. He thinks the widget will transform the world. At age 50, Ivan strongly considers quitting his job and starting his own business. However, he needs capital to market and mass-produce the widget. Ivan’s only savings is his 401(k) at the job he doesn’t enjoy. Ivan could roll the 401(k) into an IRA and take a withdrawal, but this would result in taxes and a 10% penalty because Ivan is under 59 ½.

Ivan reads about something called a ROBS arrangement – Rollover as Business Start-Up. The glossy article says that Ivan can start a new business and issue company stock. He can then open a 401(k) for the new business and transfer his old 401(k) assets over to the new one. The article goes on to say that Ivan can subsequently purchase his own newly-issued company stock within the 401(k). This arrangement will allow Ivan to provide capital to his business without being hit with any taxes or penalties. Ivan meets with his advisor to get the ball rolling!

Ivan’s advisor is concerned. She thinks Ivan’s exuberance has blinded him to the potential pitfalls of proceeding. She tells Ivan that ROBS plans are under the IRS microscope and are being carefully scrutinized for a number of reasons. For example, 401(k) plans are subject to discrimination testing, and there are questions about how ROBS plans stay compliant within those rules. Also, the underlying company stock needs to be properly valued. If this is not done with an adequately supported appraisal, Ivan could be facing a prohibited transaction.

Ivan’s advisor tells him that ROBS are not for everyone, and there are wide-ranging opinions on the validity of the strategy. In addition, there are start-up costs and other professional fees for attorneys and CPAs. Hidden promoter’s fees can also eat into Ivan’s savings. She advises he steer clear of this option.

Ivan shakes his advisor’s hand and thanks her for opening his eyes to the dangers. If Ivan’s widget did not change the world as he imagined, or if some other yet-to-be-seen obstacle caused his business to fail, he could find himself in serious trouble. A failed ROBS plan could easily leave Ivan with no business, no job, and 20 years of 401(k) savings lost. It is fortunate that Ivan sought professional advice from someone he trusted. Considering Ivan’s concerns and newfound understanding, he and his advisor put their heads together to come up with a more suitable means of funding his invention business.

Ivan’s story is an example of how important it is to look before you leap, especially when there is much to risk. Not every financial strategy is appropriate for every investor. Something as potentially convoluted as a ROBS plan – or as seemingly basic as rolling assets from a 401(k) to an IRA – will impact each individual differently. Before entering into any transaction, be sure to understand the consequences. To quote the Department of Labor, “A pure heart and an empty head are not enough.”