Invest in Yourself: Cash in Your 401(k)

Last year, when Mike Tilley lost his engineering job at Whirlpool, he decided it was time to work for himself. Buying a franchise was one option suggested by his outplacement counselor. Good with his hands and comfortable with managing projects, Tilley opted to buy an existing Mr. Handyman franchise in Kalamazoo, Michigan.

Instead of mortgaging his house or waiting for newly-approved, federally-backed small business loans to start flowing through community banks, Tilley cashed in his 401(k) retirement fund to pay the $60,000 franchise fee. He and his wife, Cathy, invested another $158,000 to buy equipment and prepare the business for growth.

“You really need to believe in yourself to do this,” said Tilley, who said he has no regrets about risking his retirement money on a business. So far, things are going well. The sluggish real estate market means more people are staying put and renovating their homes. By the third month, his franchise was breaking even and he says they are on the road to profitability.

Tilley is one of thousands of former corporate executives taking advantage of a little-known transaction called a “rollover as business startup.” It is also known as the “Entrepreneur Rollover Stock Ownership Plan” or ERSOP. Although pension experts say the Internal Revenue Service is more likely to scrutinize tax payers 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,” cautions Cliff Ennico, an attorney based in Fairfield, CT who has helped clients through the ERSOP process. “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.”

Motivated to stay out of trouble with tax authorities, most people opt to work with companies specializing in setting up these complex financial transactions. One company, founded by attorney Leonard Fischer, is BeneTrends Inc., which is based in North Wales, PA.

“At the end of the day, all we are doing is helping clients invest in themselves,” said Fischer, adding that he’s been advising clients on all sorts of pension and profit sharing issues for 50 years.

A rollover works like this: clients set up a new corporation with a defined contribution plan and use the money from their 401(k) plan to buy stock in the new company. The new pension plan must comply with a variety of tax laws and treat employees fairly, so it is definitely not a ‘do-it-yourself’ transaction.

“It’s their job to make the money (to invest),” said Fischer. “It’s our job to make sure they are in compliance with all the tax laws.”

BeneTrends charges a flat fee of $4,995 to handle the roll over paperwork. Then, they charge monthly fees to file the necessary reports and make sure the company remains in compliance with federal tax laws. “Maintaining these plans seems deceivingly simple, but it is incredibly complicated,” said Fischer.

No matter who you hire to handle the paperwork, Fischer cautions people to think carefully before risking their retirement 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 themselves.”

He said clients like the idea of creating a business opportunity that will probably outperform the stock market. He also points out that the average 50 year-old only has about $175,000 in a company-sponsored retirement account. That is not really enough money to live on after retirement—especially since people are living into their 80s or 90s.

When you start withdrawing money from a retirement fund, you will also be paying income tax totaling 30 to 40 percent of the amount withdrawn.

Evaluating all the pros and cons before cashing in your 401(k) is important, according to Ennico, the small business attorney and author of several books on eBay and other small businesses. “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.”

Meanwhile, Tilley said he has no regrets about buying his Mr. Handyman franchise. He deals with the clients while his wife, Cathy, handles the marketing. They have a couple of employees, including a carpenter. He attributes his successful transition from executive to entrepreneur to the excellent training program provided by Mr. Handyman.

“They taught me how to make it work,” he said, adding that he’s working harder than he ever did at his corporate job, especially now, since he has no retirement fund to fall back on. “I’ve got to do everything in my power to make this successful.”