Betting Your Retirement on the Business

You can use money from an IRA or 401(k) to start a business, but it's essential to understand the rules and be prepared to pay steep fees

by Karen E. Klein

I would like to start my own business. Can I take money out of my IRA or 401(k) "penalty-free" to start this company, as some advertisements claim?

—L.L., Valley Stream, N.Y.

Yes, technically it is possible to use retirement money you have invested in an IRA or 401(k) pension plan to start a business. However, there are strict rules that govern such transactions, so you must do it right—and that can wind up being costly. The other drawback is that you will be putting money you've set aside for your old age into a startup venture, an idea risky enough to give financial planners nightmares.

In terms of how to structure such a transaction, you would have to first rollover your existing IRA and/or roll your 401(k) into an IRA held by a new pension trustee firm. Your current accounts are probably invested with IRS-approved custodians, such as banks or mutual-fund companies. If you were to withdraw that money and directly invest it in your business, the Internal Revenue Service would consider that a "taxable distribution," which would be extremely costly and something you definitely want to avoid.

"Should the IRA owner run afoul of the prohibited transaction rules, the entire IRA is deemed distributed, and if the owner is under 59 1/2, there may be an additional 10% early-withdrawal tax, in addition to the regular tax on the distribution," says Barry Picker, a New York CPA and certified financial planner with Picker, Weinberg & Auerbach.

Check the Pedigrees

The large brokerage houses, such as Fidelity (FSBI) and Schwab (SCHW), allow you various investment choices for your retirement funds, but they won't allow you to invest in your own business. You also cannot be the custodian of your own funds, under IRS rules.

There are boutique pension trustees, however, that specialize in this kind of transaction—for a sizeable fee. These companies are probably placing the advertisements you've noticed. Before you hire any of them, be absolutely sure that they're IRS approved as pension custodians, says Jeff Brown, a CPA in Walnut Creek, Calif. "Such trustees offer products that permit individuals to actively invest their retirement funds into a business or franchise without taking a taxable distribution or incurring penalties," he explains.

While there are advantages in using retirement funds to capitalize a small business, it's a relatively costly infusion of capital, Brown says. On the plus side, you would have to raise substantially less third-party investment if you used your own pension funds. And you would acquire less debt than if you financed your startup through credit cards with high interest rates or even a small business loan, assuming you could get one.

Limitations on Proceeds

"You don't have anybody to pay back, and you could leverage the investment. So, for instance, if you needed $100,000 to capitalize a company, you could put in $75,000 from your IRA, and then you would probably get favorable terms to borrow the remaining $25,000" because you've already made a substantial investment of your own funds, Brown says. "Even if you were able to borrow that initial $75,000 [from a bank or private individual], the incremental debt might be 15% to 20%," he adds.

On the downside, Brown says, the boutique trustees who handle such transactions charge higher administrative fees than do traditional trustees, and setup fees may run as much as $5,000 to $7,000 to invest $250,000 or $300,000. "I was surprised at how much these things cost," he notes.

Also, if you sell your business, the proceeds will be retained in your IRA and you won't be able to access the money until you reach the age when you can legally start taking distributions—just before you turn 60. If you're already a senior, you will have to begin taking distributions from that IRA after you turn 70, regardless of the capital needs of your business.

Because of the strict IRS rules involved, you would have to structure your business as a C-corporation, which is less flexible than other business structures and more expensive to administer. " The bottom line is that such an investment is possible, but once people realize the limitations they usually opt out," Picker says. "If you do choose to go through with such an investment, you will need the services of a custodian who can guide you to make sure you don't run afoul of the rules," he adds.

Karen E. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues.