Have you heard those crazy commercials telling you how to borrow from your IRA to fund your small business? At first it sounds kind of crazy. But the more you look into it, it’s clear that it’s not just crazy. It’s 100% insane.
First, here’s how it’s done: You open your business and set up a retirement plan. You take your old IRA or 401k from a previous employer and roll it over to the new plan established by the new small business. It has to be a qualified plan like a 401k for small business owners.
This new plan is written in such a way that it can hold stock of the new small business. Once the rollover is complete, you use the cash in your new 401k to buy stock in your own company. Now the company has cash and you have stock in your 401k. So far, so good…kinda.
This is not a taxable event because the shares are still in the 401k. That cash can now be used by the small business for any purpose it sees fit.
Neal’s Notes: Want to hear another terrible idea on how to finance a business? Try borrowing the money from family. While in some unique cases, this is smart, it’s usually too risky for both your family and yourself.
So what’s wrong with this? Seems like another example of good ole’ American ingenuity…right? Well, before you slap yourself on the back too hard, consider the following problems:
1. The IRS
The IRS doesn’t consider these set-ups abusive or illegal…but they are going over them with a fine-tooth comb. There are certain compliance issues (like making sure the stock is available to all the employees, not just the owner) which are rarely adhered to. There is also the issue of stock valuation.
Since the IRS is targeting these plans, do you really want to get into that fight? I don’t. At the end of the day, this could be considered a prohibited transaction. If so, you’re going to be looking at a 100% tax penalty. Ouchie. What started off as a great way to get a small business tax deduction turned into an IRS tax debt nightmare.
You should use your retirement account to diversify your risks. This is doing the exact opposite of that. It is concentrating the risk and increasing it. Remember the employees of Enron? Many put their entire life savings into the stock. When it went south, so did they.
Do you really want to put all your eggs in one basket? It’s not a smart approach.
If you don’t have resources outside your IRA to fund your business, that might be the Universe’s way of telling you to slow down. Rethink it. Sometimes just because you can do something doesn’t mean you should. That’s certainly the case here. You can use your IRA to fund your business, but I strongly encourage you not to do so.
There are far better ways to find money to start your business. Borrow the money, redeem US savings bonds, get a second job. Do whatever you must. But don’t use your retirement money to fund your start-up company.
photo credit, Flikr, Woodleywonderworks
Khaleef @ KNS Financial says
I didn’t even know about this option. You’re right, I wonder how many people who set this up make the stock available to all employees.
Like you said, I wound’t want to have to justify how I priced the stock! And I definitely wouldn’t want my 401k to consist of the stock of only one company – even if I owned it!
Rich with SFP says
You are right, that is insane. I don’t see how the IRS would find that OK from a valuation standpoint as you know anyone doing this would be using the money as working capital for start up expenses and not creating real asset value. Thanks for the info.
I never knew that’s what they were talking about!
Could you start the business and then roll the IRA into a new 401K and take a loan?
Neal@Wealth Pilgrim says
Thanks Alma. Very kind of you to take the time to comment. I appreciate it.
Alma Jones says
Very nice article and thanks for useful information