While you are unable to borrow funds from an IRA to give yourself or a business you own capital, you are able to do so using funds from a qualified plan, such as a 401(k). The following case study outlines the different options in structuring these types of transactions, which can be performed in typical or self-directed qualified plans.
John was recently retired from the fire department and ready to move on to the next phase of his life. At 54 years young, John knew he wasn’t ready for “full-time” retirement and had been thinking about starting his own business for several years. As his retirement date approached, John spent a lot of time exploring various business opportunities. John was an avid fisherman and ultimately decided to start a business that revolved around his knowledge of and longtime passion for fishing, a bait & tackle store called “Fully Involved Fishing, Inc.”
John estimated he would need $300,000 to secure a retail location, build out the store, buy inventory and cover operating and overhead costs for the first year. As for employees, John planned to hire off-duty firemen, strictly on a part-time basis. John was familiar with self-directed IRAs and, with approximately $400,000 in his rollover IRA, he was hopeful that he could use some of his retirement savings to fund his new venture.
In discussing the options with his CPA, John learned that it would be a prohibited transaction for him to lend money from his IRA to himself or to a business he owned. He was disappointed to learn that it would also be prohibited to buy a piece of real estate in his IRA and lease that property to a business he owned. But, the CPA had some good news as well. The CPA explained that the rules are different for IRAs as compared to the rules for qualified plans, such as a 401(k). If properly structured, John would be able to utilize his retirement account to fund the startup of his new business by establishing a 401(k) for Fully Involved Fishing, Inc. and rolling his IRA funds into this new qualified plan.
In discussing his plan, John’s CPA and attorney explained that once the corporation or LLC was established and the company’s 401(k) plan was adopted, John could roll his IRA into the new company’s 401(k) plan. John would then have three options for accessing the funds.
Option 1 – John Takes Participant Loan From His 401(k)
John’s CPA explained that he could take a loan from his 401(k) and repay the loan over a five year period at market interest rates, with all the interest going back into his own account. However, the loan amount would be limited to the lesser of 1) $50,000; or, 2) 50 percent of the balance in his 401(k). With $400,000 in his account, John would be limited to borrowing only $50,000. This was far less than he needed to start the business.
Option 2 – John’s 401(k) Buys Real Estate and Leases to the Business
John’s CPA explained that while leasing real estate from his IRA to his business would be prohibited, the rules for 401(k) accounts would allow for leasing real estate from his 401(k) plan to the business under certain conditions. Those conditions and limitations, however, were strict. John could buy a retail location in his 401(k), but he would only be able to lease 25 percent of the property to his business and no more than 25 percent of the 401(k)’s income could come from real estate leased to his business. With $400,000 in his account, John would not be able to satisfy both of these requirements.
Option 3 – John’s 401(k) Buys Stock in the New Company
Under this option, John would buy original issue stock in his new company within his 401(k) account. This is commonly referred to as setting up a ROBS Plan (Rollover as Business Start-up). His 401(k) would write a check to the company and in exchange, the company would issue stock to his 401(k). John, as president of the company, would deposit the funds onto the company’s checking account and could use the funds as needed to secure a location, buy inventory, and cover operating expenses. Meanwhile, his 401(k) account would benefit by sharing in the company’s profit as a shareholder.
As he reviewed the alternatives, John realized that buying company stock in his 401(k) was clearly the best option for utilizing his retirement account funds.
After doing some more planning, John decided to purchase $200,000 of stock with his 401(k) and another $100,000 with personal funds. The corporation retained 200,000 shares of authorized but un-issued stock that would allow John and his 401(k) to add additional capital to the company in the future, if needed. Because Fully Involved Fishing, Inc., was set up as a C-Corp, John was able to take a reasonable salary from the company for his duties in managing the store and running the company. Realizing the tax benefits and flexibility of his 401(k), John decides to defer the first $20,000 of his salary back into his 401(k) account, reducing his taxable W-2 income.
“This is incredible!” thought John. “I was able to use my retirement account to help fund my new business, I can take a salary from the business to pay my living expenses, and I can even put some of that salary back into my retirement account to lower my taxes. In the future, as the business becomes profitable, my 401(k), which owns 66 percent of the stock will get 66 percent of the profits distributed as dividends.”
Anyone interested in exploring the use of retirement accounts to fund a new business should consult with a CPA or tax advisor and consider all of the tax, legal and financial implications, including these key points:
- The IRS requires and fully expects the 401(k) Plan will be funded with salary deferrals and profit sharing contributions to ensure the requirements of a Qualified Plan being used for planning and saving for retirement under 401(a) of the Internal Revenue Code and not exclusively for the purpose of funding a new business.
- If you wish to take a salary from the business, the entity must be taxed as a C-Corp.
- Even if you don’t take a salary, if the entity is taxed as an S-Corp, partnership or other pass-through entity, the 401(k) may be subject to UBIT/UBTI (Unrelated Business Taxable Income).
- Advanta IRA’s individual(k) plan is only suitable for businesses that do not have any common law employees other than the owners of the business and their spouses. If the business hires employees who are eligible to participate in the 401(k) plan (work more than 1000 hours per year), you need to hire a plan administrator to do discrimination testing and other administration services required by the IRS and Department of Labor.
If you have questions about this article or wish to learn about self-directed individual(k) plans, please contact us.