Planning Briefs

Start A Business With Your IRA Or 401(k)

Published Tuesday, April 3, 2007 at: 7:00 AM EDT

Starting your own business is part of the American Dream. But it is fraught with risk. The vast majority of new businesses fail. Yet who’s to say whether your idea could work? And not pursuing your dream could leave you regretful for life.

If you decide to take the plunge, a major challenge is financing your start-up. Banks often want no part of backing startups, and every loan payment drains capital that could have fueled growth. You might try raise funds through private investors, but they usually require a large chunk of your equity and may make other demands you’re not willing to meet.

As a last resort, you could tap money socked away in an Individual Retirement Account, 403(b) or 401(k). Spending money meant to fund your life after work is obviously dangerous. Plus, you must pay income tax when withdrawing from a traditional IRA or 401(k), and an early-withdrawal penalty is assessed if you’re under age 59½.

However, if you’re willing to risk a portion of your retirement savings to take a bet on your business idea, you can avoid taxes and penalties by structuring your company as a retirement plan investment. It’s a little-known financing technique that could work if you’re young enough to recover from a major withdrawal from your retirement account or certain that you’ll be getting an inheritance or other windfall to fund retirement.

To use your retirement funds to finance a new business venture, some technical details must be in order, and a number of consulting firms specialize in helping structure these uncommon transactions. Typically, it involves taking funds from an IRA, 401(k), or 403(b) and investing directly into your new business. The retirement essentially owns shares in your company through a “private placement transaction.” The process differs slightly depending on which type of account you tap.

To use IRA money to fund your new business:

Organize the business as a “C” corporation.
Request IRS approval for the transaction.
Issue shares of the company to your IRA, and have the IRA custodian release cash from your account to pay for the stock.

To use 401(k) or 403(b) funds for your new business, the approach is slightly different. You don’t need IRA approval and you simply shift your retirement funds from one qualified account to another. The basics steps:

Organize the business as a “C” corporation.
Create a new retirement plan for the corporation.
Roll funds from your existing retirement plan into the corporation’s new plan.
Have the new plan buy shares in your company.

While these transactions are not very complex, it is best to speak with and consider engaging one of the handful of consulting firms specializing in this area. Expect it to cost up to $5,000 initially to tap the funds, and there will be recurring annual costs of approximately $1,500 to maintain the plan.

Finally, don’t underestimate the risk of betting your retirement savings on the success of your new company. The high stakes gamble could pay off, but you don’t want to risk your retirement savings without your eyes wide open.

This article was written by a professional financial journalist for Preferred NY Financial Group,LLC and is not intended as legal or investment advice.

An individual retirement account (IRA) allows individuals to direct pretax incom, up to specific annual limits, toward retirements that can grow tax-deferred (no capital gains or dividend income is taxed). Individual taxpayers are allowed to contribute 100% of compensation up to a specified maximum dollar amount to their Tranditional IRA. Contributions to the Tranditional IRA may be tax-deductible depending on the taxpayer's income, tax-filling status and other factors. Taxed must be paid upon withdrawal of any deducted contributions plus earnings and on the earnings from your non-deducted contributions. Prior to age 59%, distributions may be taken for certain reasons without incurring a 10 percent penalty on earnings. None of the information in this document should be considered tax or legal advice. Please consult with your legal or tax advisor for more information concerning your individual situation.

Contributions to a Roth IRA are not tax deductible and these is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).