Risk Versus Reward
There are some inherent risks in using 401(k) retirement funds in a ROBS to start up a new business. Where most entrepreneurs get into trouble is in applying the plan’s terms incorrectly or operating the plan in a manner that discriminates.
For instance, if the employer hires additional staff to help him or her run the business but refuses to allow them to participate in the plan, this discriminatory action would disqualify the plan. However, just the simple omission of failing to notify new employees in writing of the availability and existence of the plan can also invalidate it.
What this means in terms of finance is the total amount of the rollover—say you rolled over a million dollars—would now be subject to not only taxes but potentially an additional tax because you withdrew them from another plan before turning 59 ½ years old.
Note: While you may hear this additional tax referred to as a “penalty for early withdrawal or early distribution," it is not a penalty. It is an additional 10 percent tax. Penalties can be abated (reduced in amount) but taxes cannot be abated according to the IRS.
Another mistake that entrepreneurs using the ROBS make that disqualifies their plans is failing to file all the required IRS forms such as:
- Form 5500 – Annual Return/Report of Employee Benefit Plan
- Form 5500-EZ – Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan
- Form 1120 – U.S. Corporation Income Tax Return
- Form 1099-R – Distribution from Pensions, Annuities, Retirements, Profit Sharing Plans, IRAs, Insurance Contracts, etc.
While applying for a favorable determination letter (DL) is not required for individually designed retirement plans, it would be a wise idea for those using the ROBS program to make application. While a DL does not give plan sponsors protection or guarantee that the plan will be deemed a qualified plan, it could reveal any problem areas that would prevent the plan from meeting the requirements of Code 401(a).