GREAT 40 IDEA: Invest in Yourself by Tapping Your 401(k)
After losing his engineering job at Whirlpool in 2009, Mike Tilley decided it was time to work for himself. He researched a variety of franchises before he and his wife, Cathy, bought an existing Mr. Handyman franchise in Kalamazoo, Michigan, by cashing in his 401(k) retirement fund.
Tilley used the money to pay the $60,000 franchise fee and invested another $158,000 to buy equipment and to cover other business expenses.
“You really need to believe in yourself to do this,” said Tilley. He was lucky. His franchise was breaking even by the third month and was on the road to profitability by the end of the first year.
Tilley is one of thousands of former corporate executives taking advantage of a little-known transaction called a “rollover as business start-up” by the IRS. It is also informally known as the “entrepreneur rollover stock ownership plan” or ERSOP. Although pension experts say the IRS might scrutinize taxpayers who tap into their retirement accounts to fund businesses, it is still an attractive option to consider, if done right.
“The penalties for not complying with the rules are staggering,” said Cliff Ennico, an attorney based in Fairfield, Connecticut, who counsels clients cashing in their retirement funds to purchase businesses. “If the IRS determines that a 401(k) rollover is a prohibited transaction, it can trigger excise taxes on top of taxes, interest, and penalties for premature distribution of 401(k) funds.”
It's a good idea to work with a company that specializes in these transactions. BeneTrends Inc., founded by Leonard Fischer, is based in North Wales, Pennsylvania. Every year, the company helps thousands of new entrepreneurs execute these rollover transactions.
“At the end of the day, all we are doing is helping clients invest in themselves,” said Fischer, who has been dealing with pension and profit-sharing issues for 50 years.
Fischer said it works like this: clients set up a new corporation with a defined contribution plan and roll over the money from their 401(k) into the “qualifying employer securities” or stock in the new company. “It's their job to make the money,” said Fischer. “It's our job to make sure they are in compliance with all tax laws.”
BeneTrends charges a flat fee of $4,995 to handle the paperwork. Then, they charge a monthly fee of about $100 to make sure the company remains in compliance. “Maintaining these plans seems deceivingly simple, but it is incredibly complicated.”
Fischer cautions that not everyone should risk investing their nest egg on a business.
“It's not like gambling in Las Vegas, but there is an investment risk,” he said. “The person has to feel comfortable investing in himself.”
He also points out that the average 50-year-old has about $175,000 in a company-sponsored retirement account, which is not really enough to live on after retirement. “It makes sense to build a business that will outperform the stock market,” said Fischer.
He also said that if you start withdrawing retirement funds to live on, most people will pay 30 to 40 percent in income taxes.
Ennico, a small business attorney and author of several books on small business, said it is critical to proceed with caution. “If your franchised business ultimately fails, the profit-sharing plan will be left holding worthless stock, which may have a catastrophic impact on your financial future.”
It is important to understand all the risks of “betting the ranch” on a franchise, because “that's exactly what you are doing.”
Meanwhile, Tilley admits he's working harder than he ever did before, especially since he has no retirement fund to fall back on. “I've got to give it a shot and do everything in my power to make this successful.”