Funding Your New Business

Case Study: Funding a Business with Retirement Funds

The following case study outlines three ways of funding your new business with retirement funds.

John recently retired from the fire department. At 54, John isn’t ready for “full-time” retirement. He dreamed of starting his own business for several years. John spent time exploring various business opportunities. He is an avid fisherman and decides to start a business based on this passion. He wants to open a bait & tackle store called “Fully Involved Fishing, Inc.”

Newly retired man fly fishes in a stream

John needs $300,000 to secure a retail location, build out the store, buy inventory, and cover operating and overhead costs for the first year. John plans to hire off-duty firemen, strictly on a part-time basis. He has $400,000 in his IRA and wants to use some of these savings to fund his new venture.

John’s CPA explained that rules differ for IRAs and qualified plans like 401(k)s. IRAs don’t allow account owners to borrow funds from the plan or use the IRA to directly start a new company. But, if properly structured, John can use his retirement account to fund the startup of his new business. He can open a 401(k) for Fully Involved Fishing, Inc., and roll his IRA funds into this new qualified plan.

Once the corporation or LLC is established, the company adopts a 401(k) plan. John rolls his IRA into the new company’s 401(k). He now has three options for accessing the funds.

3 Ways of Funding a Business with Retirement Funds

Option 1 – Take a Participant Loan from the 401(k)

John takes a loan from his 401(k). The requirements mandate repayment of the loan over a five-year period at market interest rates. All the interest reverts into his own account. However, the loan amount is limited to the lesser of $50,000 or 50 percent of the balance in his 401(k).

With $400,000 in his account, John can only borrow $50,000. This is far less than he needs to start the business.

Option 2 – John’s 401(k) Buys Real Estate and Leases to the Business

Leasing real estate from his IRA to his business is prohibited. But 401(k) rules allow the lease of real estate from the plan to the business. However, there are specific and strict conditions. John can only lease 25 percent of the property to his business. Additionally, no more than 25 percent of the 401(k)’s income can come from real estate leased to his business.

With $400,000 in his account, John cannot satisfy these requirements.

Option 3 – John’s 401(k) Buys Stock in the New Company

John buys 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 startup). His 401(k) writes a check to the company in exchange for company stock for his 401(k). John, as president of the company, deposits the funds into the company’s checking account. He uses the funds to secure a location, buy inventory, and cover operating expenses. Meanwhile, his 401(k) account benefits by sharing in the company’s profit as a shareholder.

In John’s situation, buying company stock in his 401(k) is the best option.

Moving forward, John purchases $200,000 of stock with his 401(k) and another $100,000 with personal funds. The corporation retained 200,000 shares of authorized but unissued stock that allows John and his 401(k) to add additional capital to the company in the future, if needed. Fully Involved Fishing, Inc., is set up as a C-Corp. Therefore, John takes 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.

In the future, as the business becomes profitable, John’s 401(k), which owns 66 percent of the stock, will receive 66 percent of the profits distributed as dividends.

Considerations when Funding a Business with Retirement Funds

Are interested in exploring the use of retirement accounts to fund a new business? Consult with a CPA or tax advisor and an attorney to learn all of the tax, legal and financial implications, including these key points:

  • Per the IRS, the 401(k) plan is funded with salary deferrals and profit-sharing contributions. This ensure the qualified plan is 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 unrelated business income tax (UBIT) if it receives unrelated business taxable income (UBTI).

How a Solo 401(k) with Advanta IRA Works to Help Fund Your Business

Advanta IRA’s self-directed solo 401(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 part-time employees eligible to participate in the 401(k) plan, you must hire a plan administrator to perform discrimination testing and other administration services required by the IRS and Department of Labor.

Rules for part-time employee eligibility for the 401(k):

Per the SECURE Act passed in 2019, to qualify for participation in 2024, employees must have worked more than 500 hours within a 12-month period for three consecutive years.

The SECURE Act 2.0 relaxed these requirements. To qualify for 401(k) participation in years after December 31, 2024, part-timers must work at least 500 hours a year for two consecutive years.

If you have questions about this funding your new business with retirement funds or wish to learn about self-directed individual(k) plans, please contact Advanta IRA for a free consultation.