An unusual retirement account rollover could be the strategy that unlocks clients’ entrepreneurial desires—or the mistake that ROBS them of their dream.

A rollover for business start-ups (ROBS) allows investors with a retirement account like an IRA or 401(k) to use their savings, tax-free, to start a business—with a few catches.

Greg Sullivan, president and CEO of Sullivan, Bruyette, Speros and Blayney, a McLean, Va.-based registered investment advisor, argues that if clients require something like a ROBS to found a business, they may not be prepared to own and operate their own company.

“I feel like these ROBS are setting people up for failure,” said Sullivan. “If you don’t have the capital to truly set up the business and you have to turn to your 401(k) or IRA to do that, you may not be well-capitalized to build your business.”

Guidant Financial, a specialist in business and franchise financing that offers these rollovers as its flagship business, reported that the ROBS is the third most popular funding option for entrepreneurs so far in 2018. While most new businesses are purchased with cash, 22 percent of the respondents in a survey of more than 2,600 small business owners told Guidant that they used their 401(k) to launch their business.

Guidant said it has seen a 17 percent increase in lending transactions this year, along with a 23 percent increase in year-over-year revenue.

Guidant often combines a ROBS with other forms of financing, like Small Business Administration loans. The firm noted that it has seen a 97 percent increase in SBA loans year over year.

According to Guidant, a ROBS allows entrepreneurs to roll assets from an existing retirement account into a new 401(k) sponsored by their new business, which then would allow them to purchase stock in the new business.

Doing so, however, could take a bite out of a client’s retirement prospects.

“It’s like saying someone should dip into their Social Security before they’re eligible because they have a good idea that they want to pursue,” said Sullivan. “That’s supposed to be their fallback position, the support for when they get older. A retirement plan shouldn’t be thought of as a tool kit for your day-to-day life or for starting businesses. The whole purpose is to be thinking long term.”

The loss of retirement benefits from using these rollovers compounds over time, which could cause entrepreneurs to fall drastically behind on their savings.

At St. Louis-based Plancorp, advisors do not use these rollovers for business start-ups with their clients, said Susan Conrad, chief client experience officer.

“Most of the time, the 401(k) plan is the largest asset for investors,” said Conrad. “A rollover for business start-ups allows individuals to leverage this balance for start-up costs without taking a cash distribution, which creates a taxable event. This all sounds great, but as with most things, there are risks to consider. The most obvious is that you are putting your retirement nest egg in jeopardy if the start-up fails.

“Over 75% of start-ups fail, so this is a real consideration.”

A business start-up rollover requires prospective entrepreneurs to have $50,000 saved in a retirement account that is not offered by a current employer. They will have to be a full-time employee of their new business after going through the ROBS process.

To accomplish the rollover, entrepreneurs first have to set up their new businesses as C corporations, which can be a costly and difficult process. Then they must establish a 401(k) plan that allows the sale of company stock. ROBS providers like Guidant also offer 401(k) administration to help streamline the process, but often at a price much higher than a business owner could find on the open market.

Typically, companies charge $5,000 to help entrepreneurs set up a ROBS, not counting the cost of plan administration.

Retirement funds are then rolled over into the new 401(k) and used to purchase private stock in the C corporation, infusing cash into the new company to allow the purchase or establishment of a business.

The use of company stock in the 401(k) distorts an entrepreneur’s retirement asset allocation, noted Don Hance Jr., a financial planner and principal at LifeSighted in Pacific Palisades, Calif.

“The difference is that this is a much riskier venture,” said Hance. “This is a start-up, not at all like holding Wells Fargo or Microsoft company stock in your 401(k). A big company is likely to stay in business, but with these ROBS you have to be prepared to lose everything.”

While companies like Guidant argue that the rollovers are legal as long as the correct procedure is followed and the C corporation remains compliant, others disagree.

The ROBS appears to operate within an IRA “gray area.” Entrepreneurs using the rollover might be at greater risk of personal or business IRS audits, and they are susceptible to prohibited transaction penalties if the rollover is improperly handled or the assets misspent.

“The IRS hates these things, so they become complicated, expensive and most of the time unnecessary,” said Hance.

Some internet commenters argue that companies offering these rollovers take advantage of the natural optimism of entrepreneurial people. Guidant, for example, aggressively pitches itself as an option for potential franchisees.

“These are legitimate strategies; it’s not like we’re talking about a scam,” said Sullivan. “People who want to start a business are oftentimes overly optimistic when they get started, and lack of capital is one of the great reasons for that. Most of these people also lack the skills, knowledge, patience and experience to run a business, but they do it anyway. With this kind of rollover, they’re increasing their risk.”

If clients are ready to be entrepreneurs, they should display what Sullivan refers to as his “Five P’s.” These include:

Sullivan said that many people who come to him with an entrepreneurial idea are unable to cover all of his requirements and are unprepared to start a business.

However, in an era where interest rates are rising and banks are reluctant to lend money to entrepreneurs, the rollover for business start-ups may be a solution suited to a narrow segment of clients, Hance said.

“If you’re starting a company where you don’t have to invest too much, if you’re willing to lose a certain amount of your retirement money, and if the new business won’t have a ton of employees so you end up having to maintain a 401(k) for all of them, it might make sense,” Hance said.

Hance, who often works with high-earning, entrepreneurial young people, has had only one client approach him about a ROBS to finance a potential side hustle, but the client was ineligible because he was trying to pull the assets out of his current 401(k).

Every scenario is unique, said Sullivan, but entrepreneurs with a surefire idea for a business start-up should be able to find financing on excellent terms on the merit of their ideas, saving themselves from the potential damage to their retirement accounts.