Retirement assets often make up a substantial portion of an aspiring entrepreneur’s liquid wealth. And they’re often the most readily available source of capital, too. This is especially true for mid-career entrepreneurs. Having spent the first half of their working lives diligently contributing to their employer-sponsored retirement plans, many come to view their nest egg in a different light. A sizable IRA or 401(k) morphs into a convenient and cost-effective financing option for a new venture—one that avoids the personal dynamics of borrowing from friends and family. And while that may entice some, it’s important to understand the rules and consider the potential pitfalls carefully.
Retirement Account Distributions
One of the simplest ways to convert retirement assets into startup capital is by distributing and using the after-tax proceeds. There’s just one catch: withdrawals from traditional retirement accounts are subject to ordinary income tax. What’s more, participants under age 59 ½ may face an additional 10% early withdrawal penalty. What about Roth IRA account holders? While they can withdraw their contributions tax- and penalty-free at any time, distributions of earnings are subject to ordinary income tax plus a 10% penalty if made before age 59 ½ (or within five years of establishing the account). To avoid the 10% early withdrawal penalty, participants can structure their distributions as a series of Substantially Equal Periodic Payments (SEPPs) under Section 72(t).1
Retirement Plan Loans
Entrepreneurs can also consider taking a loan from their employer-sponsored plans, such as a profit-sharing, money purchase, 401(k), 403(b), or 457(b), if the plan allows it. Unlike withdrawals, loans are not subject to taxes and penalties, provided certain requirements are met.2 What’s more, the interest paid on the loan goes back to the original account—so you’re essentially paying yourself back. With that said, these loans are limited to the lesser of $50,000 or 50% of your vested balance and must be repaid in equal quarterly installments over five years.3
Alternatively, entrepreneurs could explore bank loans or other private debt financing. While retirement savings can be factored in as part of total net worth calculations, when it comes to personal guarantees care must be taken to avoid inadvertently pledging retirement accounts as security since the pledged portion will then be treated as a distribution.4
Owning an Operating Business in an IRA
Another option is to start and own the business directly in your retirement account.5 The advantage? No upfront tax costs. Just keep in mind, there are a host of rules, regulations, and restrictions surrounding this approach—and many aspiring entrepreneurs find them off-putting. For instance, IRA funds cannot be invested in ventures that employ the IRA owner or family members and all profits must be retained in the IRA. Plus, the IRA must have sufficient funds to cover all business expenses, including taxes, fees, and other costs.
Assuming these initial limitations don’t deter you, the first hurdle is finding an IRA custodian or trustee that permits investments in private companies. Most do not. Additionally, the business must be purchased from an unrelated party or started with cash contributed to the IRA. In other words, shares can’t be transferred or sold to the IRA by the account’s owner or another disqualified person. The latter list is quite long, covering the IRA owner’s spouse, ancestors, descendants, and spouses of descendants—or an entity 50% owned by one of these individuals. Finally, be sure to avoid other “prohibited transactions” that could result in severe penalties, such as disqualifying the entire IRA.7 Examples include just about any transaction between an IRA and the IRA owner or other disqualified person (e.g., a retirement account entering into a sale, lease, payment for goods or services, or lending with a disqualified person.)
Besides an inadvertent prohibited transaction, entrepreneurs must carefully navigate several other potential missteps. For instance, they must weigh future liquidity requirements, especially as required minimum distributions (RMDs) near.7 To facilitate these mandatory withdrawals, a company valuation must be completed each year, which many private businesses find cumbersome. If there are no liquid assets to cover the RMD, it’s possible to make an in-kind distribution of some or all of the business. However, a partial distribution would result in both the IRA holder and the retirement account owning part of the business, which can have significant tax consequences. Finally, income from an operating business is considered Unrelated Business Taxable Income (UBTI) to an IRA and subject to the 37% top marginal tax bracket after only $14,450 of income.
Rollovers as Business Startups (ROBS)
Many aspiring entrepreneurs are drawn to being their own boss in a company they’ve personally founded. The chance to employ family members also appeals. For these founders, owning the business within an IRA is not an option. However, an alternative arrangement known as “ROBS”—or Rollovers as Business Startups—could work. The ROBS approach allows entrepreneurs to use their retirement funds to launch or purchase a business that they can work for without incurring early withdrawal penalties or taxes. At a high level, a ROBS strategy involves four steps:
Deploying ROBS is a complex process requiring strict compliance with IRS regulations, and it’s important to work with a qualified professional to ensure each step is done correctly. While ROBS can be a useful financing option for some entrepreneurs, it’s not suitable for everyone. Be sure to carefully consider the risks and benefits before going this route.
Securing the Means to Fund Your Dream
Starting a business with retirement assets may seem convenient and cost-effective to many aspiring entrepreneurs. However, it’s crucial to understand the rules and regulations associated with each financing option and consider the potential risks and pitfalls carefully. Founders must weigh the potential benefits of accessing their retirement funds against the risks of non-compliance with IRS regulations, which could result in significant penalties. Ultimately, aspiring entrepreneurs must seek expert advice and research financing options thoroughly to secure their dream without jeopardizing their hard-won savings.
- Robert Dietz, CFA
- National Director, Tax Research—Investment & Wealth Strategies
- Jacob Sheldon, CFA
- Senior Analyst—Investment & Wealth Strategies
1 IRC § 72(t)(2)(iv) This requires taking SEPPs for the latter of five years or until the participant reaches age 59 ½, and can be calculated using one of the IRS-approved methods. See IRC §§ 72(t)(4), Rev. Rul. 2002-62
2 IRC § 72(p)(2)
3 IRC §§ 72(p)(2)(B)(i), 72(p)(2)(C) and Treas. Reg. § 1.72(p)-1, Q&A-3
4 IRC Sec 408(e)(4)
5 Retirement accounts can invest in private companies structured as C corporations or partnerships. However, a retirement account is not a permissible shareholder of an S corporation. Therefore, acquiring shares of an S corporation through an IRA or Roth IRA will cause the corporation to be taxed as a C corporation. See Rev. Rul. 92-73, 1992-2 C.B. 224; Reg. § 1.1361-1(h)(1)(vii).
6 See IRC § 408(e)(2)(A)(iii). The SECURE 2.0 Act of 2022, clarified that if an individual has multiple IRAs, only the IRA with respect to which the prohibited transaction occurred will be disqualified.
7 For traditional IRAs, RMDs must begin at age 73, for owners with dates of birth after 1950 but before 1960, and 75 for owners with dates of birth in 1960 or after. The account owner has until April 1 of the year following the year in which they reach their RMD age.