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Tapping retirement money is a great way to fund a startup—if it doesn't violate tax rules
As the credit crisis has made it tougher for small businesses to get funding, some would-be entrepreneurs have exploited a loophole that lets them finance a startup with 401(k) retirement funds without facing any taxes or penalties. Now the technique is catching the attention of the IRS, which plans to step up audits of such transactions. "We are seeing problems," says Monika Templeman, acting director of employee plans at the IRS. "It is open to abuse."
The transactions typically require an entrepreneur to create a new corporation, establish a 401(k) plan for it, and move existing 401(k) funds into the plan. Money from the new 401(k) is used to buy shares in the new company, and that provides the business with capital while retaining the tax advantages of the 401(k). Without such a rollover, funds withdrawn from a 401(k) are subject to income taxes. A 10 percent penalty applies if the funds are withdrawn by a person under the age of 59 1/2. Templeman says the IRS has seen questionable valuations for the new stock, and in a few cases the money was used to buy recreational vehicles and other personal assets.
While financial advisers began promoting such rollovers in the early 1990s, the credit crisis has made them more attractive. This year at least 4,000 people are likely to use the strategy, an increase over previous years, according to companies that help craft the plans. The typical transaction involves between $100,000 and $200,000 in retirement funds. Advisers charge about $5,000 for the paperwork, plus annual fees of at least $800 to run the new 401(k) plan. "When you start comparing it with a 15 to 20 percent interest rate on a loan…people are saying 'I'd rather be my own investor,' " says Jeremy Ames, chief executive of Guidant Financial Group, a Seattle company that helps business owners roll over 401(k)s.
Ames and other advocates of the rollovers say their transactions are legal. That doesn't mean the IRS will see it that way. Stephen Dobrow, president of benefits consultancy Primark Benefits, says even plans the IRS has examined may face renewed scrutiny. The IRS, he says, "can still blow up those plans even though they've passed on them once."
The bottom line: Using 401(k) funds to finance startups got more popular during the recession, but some of the transactions may violate tax law.