Funding Your New Business

Case Study: Funding Your New 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 and is ready to move on to the next phase of his life. At 54 years young, John isn’t ready for “full-time” retirement. He had been thinking about starting his own business for several years. John spent some time exploring various business opportunities. He is an avid fisherman and ultimately decides to start a business based on this passion. He decided 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. As for employees, John plans to hire off-duty firemen, strictly on a part-time basis. He has approximately $400,000 in his IRA and wants to use some of his retirement savings to fund his new venture.

John’s CPA explained that the rules are different for IRAs and qualified plans, such as a 401(k). 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 by establishing a 401(k) for Fully Involved Fishing, Inc., and rolling his IRA funds into this new qualified plan.

When discussing his plan, John’s CPA said 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 then has three options for accessing the funds.

Option 1 – John Takes a Participant Loan from His 401(k)

John can 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 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

While leasing real estate from his IRA to his business is prohibited, 401(k) rules allow the lease of real estate from his 401(k) plan to the business—under specific and strict conditions. John can buy a retail location in his 401(k), but he can only lease 25 percent of the property to his business and 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 and in exchange, the company issues stock to his 401(k). John, as president of the company, deposits the funds into the company’s checking account. He can use the funds as needed to secure a location, buy inventory, and cover operating expenses. Meanwhile, his 401(k) account will benefit 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 will 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 can 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.

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.

Further Consideration when Using Retirement Accounts to Fund a New Business

If you 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:

  • 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 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 employees who are eligible to participate in the 401(k) plan (they must work more than 1000 hours per year or more than 500 hours per year for 3 years), you need to hire a plan administrator to perform discrimination testing and other administration services required by the IRS and Department of Labor.

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.