Michael Amstein unlocked $100,000 from his 401(k) to start a cookie shop

Don Poffenroth paged through a magazine on a flight several years ago when an article grabbed his attention: Entrepreneurs could use 401(k) savings to start a business without getting hit by taxes and early-withdrawal penalties.


He and a partner had drawn up plans for a gin, vodka and whiskey distillery in Spokane, Wash., but they struggled with the best funding options.

“Neither of us was rich,” he says. “We didn’t want to have to sell shares in the company to start with. But we both had long corporate careers, and so our 401(k) plans appealed to us.”

Poffenroth and Kent Fleischmann used their 401(k) savings, a working line of capital from a local bank and additional personal savings to fund Dry Fly Distilling in 2007.

Risking their retirement nest eggs has paid off so far: Dry Fly Distilling has garnered national and international awards, and its products are sold in 19 states and several Canadian provinces. Business doubled last year, Poffenroth says. Their 401(k) funds were converted to company stock as part of the start-up, and the stock value has doubled as the $2 million firm has grown.


Relying on retirement savings to fund a business venture is a significant gamble. Only about half of small businesses survive at least five years, says the U.S. Small Business Administration. And small-business bankruptcy filings increased 44% from the third quarter of 2008 to the same quarter in 2009, according to Equifax. Further, draining or depleting retirement funds can be catastrophic financially if the money cannot be replaced.

“A small business is risky, and when you combine it with your retirement funds to launch the business, you are multiplying your risk,” says Gerri Detweiler, a personal financial adviser at Credit.com. “It’s easy to get caught up in the immediate needs of your business, but the last thing you want is to have your business fail and have nothing for retirement.”

Martin D. Hauptman, an attorney who specializes in retirement income issues, says he has two clients who invested in themselves and failed. They not only lost their businesses, they also lost their retirement savings. “One client has found a job, but the other has not and is on the verge of losing his house,” Hauptman says.

Funding sources sought

Little reliable data exist about how many entrepreneurs use retirement nest eggs to start businesses.

But business advocates and many financial firms have pushed the idea the past two years as the lagging economy and ongoing credit crunch have dried up many funding options. Last year, 39% of small-business owners said they were unable to get adequate financing, more than the 22% who said the same in August 2008, according to a 2009 year-end report by the National Small Business Association, a non-profit organization.

Prior to the housing market collapse, many entrepreneurs took out home-equity loans to provide seed capital. But that option has disappeared for most.

“Clearly, retirement assets are an untapped source of capital for many folks who are trying to start up a plan,” says Mark Davis, senior vice president at SunTrust Investment Services. “There are providers that would happily facilitate them. But I wouldn’t recommend that anybody do it to a large extent with retirement assets.”

Yet many entrepreneurs see the other funding options as risky, too.

Lenders often require loans to be collateralized with a home or other finances, says David Nilssen, co-founder of Guidant Financial Group, which helps provide small-business financing. Loans can also come with high interest rates, and the entrepreneur may have to start payments before the business even earns any money.

When Paul and Annette Cardosi purchased an existing franchise, Units Mobile Storage Franchise in Phoenix in May 2009, they decided to use their 401(k) plan savings. They converted about three-quarters of their plan into 300,000 shares of stock for the business.

“I had worked for a Fortune 500 company for 28 years and left them in 2008, and I never intended to do anything with my 401(k) plan but use it as a retirement fund — that is, until this option came about,” Paul Cardosi says.

The Cardosis had other money saved but wanted to hold onto it to run the business. When they tried to get an SBA loan, they were told they had to be in business for two years before any lender would consider them.

“It’s been a great product to sell, even in a down economy,” he says of the storage unit business. “But can I say that it is risk free? Absolutely not.”

Two ways to go

Entrepreneurs who have left their regular jobs to start a firm essentially have two options for using their 401(k)s as start-up capital. One is less complex than the other, but the more complex option can provide access to more money without fees.

The simple option is not all that different than a regular 401(k) loan.

Let’s say a lawyer or tax accountant plans a very small or single-person firm. He or she leaves a corporate job and takes the 401(k) savings from that company to the new business by establishing a 401(k) plan in that business’ name.

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At that point, a traditional 401(k) loan can be taken from the new firm’s 401(k) plan. There are restrictions, though.

The entrepreneur can only borrow the lesser of 50% of savings, or $50,000. And the loan repayment plan typically lasts for five years and requires a fee of the prime interest rate plus 1% or 2%, says Robert Cheney, a financial planner at Westridge Wealth Strategies.

The small-business owner needs to have enough steady income to repay the loan. If payments can’t be made, the loan is considered in default, and taxes and an early-withdrawal penalty will apply if the 401(k) owner is not 591/2 or older.

The second, more complex option is often referred to as a ROBS loan — Rollovers as Business Start-ups, so-named by the IRS.

Entrepreneurs using this option typically need help from a firm specializing in such work.

For a fee, these firms help the new business create its own 401(k) plan and transfer funds from the owner’s existing 401(k). The retirement money is then used to purchase company stock that’s held in the new 401(k) plan. This provides the entrepreneur’s corporation with start-up capital.

Some experts believe that it is harder for a new small business to meet IRS guidelines for ROBS loans.

The wording is not clear-cut in IRS rules, but the agency seems to require an independent appraisal of a business value to ensure tax compliance. But a start-up often has trouble meeting that goal because it may have zero value, Hauptman says.

That may be one reason why ROBS are mostly used by franchisees who are buying into an existing business.

Rhino 7 Franchise Development, a franchise developer, says that about 30% of the franchisees it worked with last year opted for a 401(k) rollover. And most were low-cost franchise purchases of $150,000 or less, says Doug Schadle, CEO of Rhino 7 Franchise.

The IRS interest in ROBS loans stems from concern that individuals might try to skirt taxes and early-withdrawal penalties by establishing a business in name only to access 401(k) funds. The IRS in 2008 issued a memorandum regarding such loans.

Before an entrepreneur decides on either option, it’s a good idea to get legal and tax advice. If an IRS audit disqualifies the plan, all the assets could be subject to a penalty, says Davis at SunTrust.

The business owner also has to consider that if he hires employees, he will be responsible for adding them to the 401(k) plan under the rules for eligibility requirement, Cheney says.

Weighing the options

But even with all the complexities and risks, many entrepreneurs believe tapping a 401(k) is the best option.

“When you first start out, no one else wants to take that risk,” says David Heitner, CEO of Heits Building Services, in Hasbrouck Heights, N.J. “I looked at different banks and institutions. They give you paperwork that is inches thick, and you have to jump through hoops.”

In 2003, he decided to roll over his 401(k) plan to use about $80,000 for his cleaning company, which provides the service for restaurants and universities.

As the business has steadily grown, the value of his 401(k) stock also has increased. He says that if he were to sell the company now, he might receive about $2.5 million.

“When you utilize your own retirement money, on the surface, it may seem high risk,” Heitner says. “But the rewards can also be there.

“I was fortunate to be in an industry that was not affected by recession, and so it has been a good move for me. … I believe that the business will take care of me in the long run.”

Via USA Today