Many individuals considering starting a business have wondered if they can use their retirement funds. Whether you were laid off from your current position or are looking for a side gig, you can use your retirement funds to invest in a new or existing business. While starting a business can be a worthwhile adventure, it can also be expensive. This article will detail how you can use your retirement funds to legally start or buy a business. Please note, that this article will present different options and is not meant to give personal advice. Instead, the purpose of this article is to help entrepreneurs or prospective entrepreneurs explore their options when starting or maintaining a business.
- One can use retirement funds to start or fund a business
- You have several options to use your savings
- The best solition for many may be the ROBS structure
Ways to Use Your Retirement Funds to Buy a Business
Taxable Distribution
Under the pretax IRA distribution rules, the distribution of IRA funds before the age of 59 1/2 is subject to income tax and a 10% early distribution penalty. Once you reach that age, there will be no penalty, however, taxes will still be due.
However, if you have a Roth IRA, any contributions made to the plan can be withdrawn at any time without tax or penalty. If you wish to withdraw earnings from the plan, you must satisfy two rules to gain the tax-free benefits of the plan. First, like a pretax IRA, you must be at least age 59 1/2. Secondly, you must have opened and funded any Roth IRA for at least five years. This is known as a qualified distribution. If you do not satisfy these conditions, your Roth distribution may be subject to tax and penalties.
Of course, once funds are distributed from the plan, they no longer enjoy the benefits of being sheltered from tax. This option is probably the least favorable one for most retirement account holders.
Self-Directed IRA
The Self-Directed IRA is the most popular vehicle for IRA savers to make alternative asset investments, such as an investment into a private business.
If one wishes to set up a Self-Directed IRA to fund a new business, the IRS-prohibited transaction rules under IRC 4975 will likely prohibit the investment. This is especially true if the IRA owner and/or a disqualified person is seeking to own 50% or more of the business.
In cases where the IRA will be a passive minority investor of less than 50%, a Self-Directed IRA could be a viable option. However, the UBTI tax could be triggered and impose up to a 37% tax on the net income associated with a pass-through business, such as an LLC. One way to avoid this tax is to set your business up as a C Corporation.
Learn More: Using a Self-Directed IRA to Invest in a Business
The Solo 401(k) Loan
A new business can set up a 401(k) plan and then use a loan feature to fund the business. This option will be viable for any entrepreneur who has IRA or rollover 401(k) funds and needs 50% or less to invest in the business. Again, you don’t want to run afoul of the IRS rules.
Any business can set up a 401(k) plan. If you are a sole proprietor, you may be able to open a Solo 401(k) plan. So long as there are no other full-time employees other than a spouse or other owner, you can generally “go solo.”
The Solo 401(k) plan is unquestionably the best plan for the self-employed. The plan features high annual contribution limits, the aforementioned loan feature, and the ability to invest in alternative assets, such as real estate and private businesses.
IRC Section 72(p) allows a plan participant to borrow from his or her 401(k) plan, assuming the plan documents allow for it. Before setting up your plan, make sure the loan option is available!
A Solo 401(k) loan is permitted at any time using the accumulated balance of the 401(k) as collateral for the loan. One can borrow up to either $50,000 or 50% of their account value – whichever is less.
The loan must 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. The lowest interest rate permitted to be used for the loan is the Prime Rate as per the Wall Street Journal, which as of August 1, 2024, is 8.50%.
The 401(k) loan can be used for any purpose, including funding a new business. Best of all, the plan participant would get tax-and penalty-free use of the funds and all loan payments, including interest, will be paid back to the plan as a return on investment.
In sum, the 401(k) loan option is a great idea for any entrepreneur that needs $50,000 or less to fund a business. However, not all Solo 401(k) providers offer a Solo 401(k) loan. IRA Financial is one of the few Solo 401(k) providers that allow individuals to take a Solo 401(k) loan right after opening their account. To learn more, contact us directly.
Read More: Solo 401(k) Eligibility
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ROBS 401(k)
The Rollover Business Startup Solution (ROBS 401(k)) is the only legal way one can directly use retirement funds to invest in a business in which he or she is personally involved with. Unlike the 401(k)-loan option, which involves a personal investment of the loan proceeds in the business, ROBS involves the investment of the 401(k) funds directly into the corporate business. The following explains how the ROBS works.
The ROBS 401(k) typically involves the following sequential steps:
- (i) an entrepreneur or existing business owner establishes a new C Corporation;
- (ii) the C Corporation adopts a prototype 401(k) plan that specifically permits plan participants to direct the investment of their plan accounts into a selection of investment options, including employer stock, also known as “qualifying employer securities.”;
- (iii) the entrepreneur elects to participate in the new 401(k) plan and, as permitted by the plan, directs a rollover or trustee-to-trustee transfer of retirement funds from another qualified retirement plan into the newly adopted 401(k) plan;
- (iv) the entrepreneur then directs the investment of his or her 401(k) plan account to purchase the C Corporation’s newly issued stock at fair market value (i.e., the amount that the entrepreneur wishes to invest in the new business);
- v) the C Corporation utilizes the proceeds from the sale of stock to purchase an existing business or to begin a new venture.
The ROBS solution takes advantage of an exception to the IRS prohibited transaction rules under IRC Section 4975 that allows a 401(k) to purchase qualifying employer securities, also known as C Corporation stock, for fair market value. The ROBS must involve a 401(k) plan and a C Corporation. An IRA or LLC cannot be used in a ROBS. However, ROBS is commonly used by individuals interested in purchasing or owning a franchise. Since franchises have elevated startup costs, ROBS allows individuals to use their retirement accounts to fund their new business venture. Yet, due to the complexity of ROBS, it is recommended that individuals consult with tax professionals, like IRA Financial Group, who have extensive experience in creating these new structures.
Related: The Beginners Guide to Rollover Business as Startups (ROBS 401(k))
Conclusion About Business Funding
Using retirement funds is a popular way to get your business venture off the ground. Of course, you should know the risks of doing so. Do your diligence before risking it all on a business. If your business fails, you have much more to lose than if you used personal funds.
We’ve highlighted several options for using retirement funds to start a business. Taking a taxable distribution from your plan should be a last resort. However, it may be a decent option for some people. Using a Self-Directed IRA will limit your ability to be personally involved in the business. Of course, if you are looking to simply invest in a business, this me be the route for you.
The 401(k) loan option is great for those that do not need a lot of capital. However, if you need more than $50,000, you will have to look elsewhere for additional capital.
ROBS, although costly, may be the best way to use retirement funds to make your business idea come to life. This is especially true if you need more capital than a 401(k) loan can provide and want to personally be involved in the business itself.
As always, you should speak with a financial advisor to devise a plan that works for your unique situation. Do your research before getting started to give yourself the best chance at a successful business venture. Contact us directly to receive a free consultation.
