Small businesses are the bedrock of the US economy. According to SBA.gov, there are 31.7 million small businesses in the US. 81 percent, or 25.7 million, have no employees. From 2000 to 2019, small businesses created 10.5 million net new jobs while large businesses created 5.6 million. Small businesses have accounted for 65.1% of net new job creation since 2000. Unknown to many small business owners, in many instances, one could use their IRA or 401(k) to help finance their business. This article will explore the manners in which small business owners can use their retirement funds to finance a business.
Key Points- Starting a business is a dream for many Americans
- If you lack capital, you can use retirement funds to help finance your business
- Depending on your situation, you have options, like distributions, loan or ROBS.
Taxable Distribution
Taking a taxable distribution from one’s retirement account is generally the least tax-efficient manner to gain access to the funds. In the case of a traditional pretax IRA, a distribution prior to the age of 59 1/2 is subject to ordinary income tax plus a 10% early distribution penalty. Whereas, a distribution after the age of 59 1/2 is subject to ordinary income tax only.
Tax is based on the fair market value of the cash or asset distributed. Alternatively, in the case of a Roth IRA, Roth IRA contributions can be taken at any time without tax, although, the earnings generated in the Roth are subject to similar distribution rules as a traditional IRA, with one difference. Once you reach the age of 59 1/2, and the the Roth has been opened for at least five years, there are no taxes due on distributions.
60-Day Rollover
An IRA owner is permitted, once every 12 months, to take an in-kind distribution of IRA funds. You may use these funds for any reason, including business funding, however, you have 60 days to contribute the money back into a retirement plan. Failure to do so will result in a taxable distribution, and be subject to the above-stated taxes and possible penalty.
This is a great option if you need temporary use of the funds. Just remember that those funds need to go back to your retirement plan within the time-frame allotted to avoid taxes.
401(k) Options
Unlike an IRA, in the case of a 401(k) plan, a plan participant cannot gain access to his or her 401(k) funds until there is a triggering event. Essentially, you need one of the following to happen:
- Reach the age of 59 1/2
- Leave your job
- Plan is terminated
- Rolled funds into 401(k) plan
- Hardship distribution
In most cases, if you wish to use 401(k) money to help fund a business, you need to separate from your job. Therefore, if you have a 401(k) from a previous employer, you can withdraw them from your account to help finance your business.
Self-Directed IRA
The Self-Directed IRA is the most popular vehicle for retirement account holders to invest in privately held businesses. In general, a Self-Directed IRA can invest in anything except life insurance, collectibles, and any investment involving a disqualified person.
Accordingly, if an IRA is used to invest or lend funds to a business owned by the IRA owner, it is crucial to verify that the IRA owner, nor any disqualified person, owns 50% or more, in the aggregate, of an LLC, or have voting control in the case of a corporation.
For example, if the IRA owner owns more than 50% of an entity, using a Self-Directed IRA to finance that business would be risky and would likely violate the IRS prohibited transaction rules. Even when owning less than 50%, the investment must still be made to exclusively benefit the IRA itself, and not any disqualified person.
At the end of the day, if you wish to be involved in the business you are investing in, using a Self-Directed IRA is not the best option. Of course, if you are a passive investor, it may make sense for you.
401(k) Loan Option
Unlike an IRA, where the IRA owner is not permitted to borrow even one dollar from the plan, many 401(k) plans offer a loan option. A 401(k) loan is permitted at any time using the accumulated balance of the 401(k) as collateral for the loan.
A 401(k) participant can borrow up to $50,000 or 50% of their account value – whichever is less. This loan has to be repaid over an amortization schedule of five years or less with payment frequency no greater than quarterly. The interest rate must be set at a reasonable rate of interest, generally interpreted as prime rate as per the Wall Street Journal, which is 5.50% as of August 30, 2022. The interest rate is fixed at the time of the loan application.
The great thing about taking advantage of the 401(k) loan option, is that the plan participant will get tax- and penalty-free access to the funds, and can use it to help finance a business. Plus, the interest paid will go back to your 401(k) plan.
Solo 401(k)
If you are self-employed or have a small business with no full-time employees, other than the owners and their spouses, your business can establish a Solo 401(k) plan that includes a loan option. As long as the plan documents allow for it and the proper loan documents are prepared and executed, a participant loan can be made for any reason. The Solo 401(k) loan is received tax- and penalty-free provided loan payments are paid on time. IRA Financial is one of the few self-directed plan providers that offers 100% open architecture Self-Directed Solo 401(k) plans to small business owners that contain a loan feature.
In sum, if you need less than $50,000 for business financing, then the 401(k) loan option may prove to be a cost effective and wise option.
ROBS Solution
The Rollover as Business Startup (ROBS) Solution is an IRS and ERISA approved structure that allows investors to use their retirement funds to invest in a new or existing business/franchise. It is the only legal way to use more than $50,000 of retirement funds to invest in a business you or another disqualified person will be personally involved in without triggering the IRS prohibited transaction rules.
The ROBS solution takes advantage of an exception to the IRS prohibited transaction rules found in IRC 4975(d). It involves the establishment of a C Corporation. The C Corporation will then establish a 401(k) plan. Pretax IRA or 401(k) funds can then be rolled into the 401(k) plan tax-free. The 401(k) funds will then be transferred to the C Corporation in return for stock. Now, the plan participant will become an employee of the corporation.
In fact, the ROBS Solution can also be used by an existing C Corp. Note – only a C Corporation and 401(k) can be used in the ROBS solution, as an IRA or LLC would cause the structure to fail the prohibited transaction rules exception.
In sum, the ROBS solution is truly the only tax-free solution one can use to invest in a business using retirement funds where the business will be controlled by a disqualified person.
Conclusion
Unfortunately, many small business owners are not aware that they can actually use their retirement funds to help finance a new or existing business. Those that do know may think a taxable distribution is their only option.
As outlined above, you have several different options, depending on who owns the business, how involved you want to be, and how much capital you need.
If you plan on being a passive investor, then the Self-Directed IRA may be perfect you. If you want to be involved, and your 401(k) plan allows for a loan, you can use up to $50,000 to fund your business. If you need more money, then the ROBS solution can help your business ownership dreams. A taxable distribution should only be used as a last resort. The aforementioned options are far superior.
Starting your own business is an exciting time. However, before tapping your retirement funds, ensure that the business is in the best situation to succeed. If it fails, you are putting your golden years at risk. Talk to qualified professionals before getting started.
