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How to Use Retirement Assets for Startup Expenses

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What You Need to Know

  • Clients with significant 401(k) balances may wish to explore the 401(k) loan option for short-term startup funding.
  • If a startup is organized as a C corporation, the client can roll over retirement funds into its new 401(k).
  • The client won’t incur any penalties or income tax liability when doing this rollover, but very specific rules apply.

The number of startup businesses in the U.S. grew significantly between 2019 and 2020, even as business operations across the nation shut down and implemented widespread layoffs at the height of the COVID-19 pandemic.

While it’s difficult to pinpoint the exact cause, startup business grew by 24% despite — or perhaps because of — the pandemic during this time. Many employees may have opted to start their own businesses to gain control over their earnings or because of limited employment opportunities.

Whatever the reason, these newly minted business owners often face the same problem: a need for funding. Often, the bulk of the client’s assets are invested in retirement accounts — and many of these entrepreneurs may not know that those retirement funds could provide a viable funding solution.

Business Funding From a Retirement Account: Traditional Options

Unfortunately, clients can’t use their personal self-directed IRAs to invest in their businesses. The prohibited transaction rules would prevent these clients from paying themselves a salary, because self-directed IRA owners can’t work for businesses the IRA has invested in.

Further, many clients would incur an early withdrawal penalty for traditional retirement account distributions that are taken before the client reaches age 59½. That 10% penalty applies on top of ordinary income tax on the distribution.

Clients with significant 401(k) balances may wish to explore the 401(k) loan option for short-term funding. Plan loans are both tax and penalty-free if structured properly.

On the other hand, the amount the client can borrow is limited to (1) the greater of $10,000 or half of the account balance, or (2) $50,000, whichever is less. (The loan amounts were expanded for 2020 in response to the COVID-19 pandemic.)

Generally, the loan balance must be repaid within five years, and payments must be made at least quarterly.

401(k) Rollover: A Nontraditional Option

There are, however, less traditional routes that can allow a new entrepreneur to use retirement funds to self-fund a business. If the client’s new business is organized as a C corporation, that C corporation is legally permitted to form a retirement plan and invest in its own company stock — called qualifying employer securities.

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To fund the new business, the client simply rolls over retirement funds into the C corporation’s new 401(k). The new 401(k) can then buy qualifying employer securities to provide funding for the new business.

The client won’t incur any penalties or income tax liability when engaging in this type of rollover transaction. But very specific rules apply, and the client must be careful to avoid running afoul of any prohibited transaction rules.

Potential Traps

Notably, the client can use a newly established 401(k) to purchase qualifying employer securities only if the business is set up as a C corporation. S corporations, LLCs and other pass-through entities don’t qualify.

The C corporation structure can be undesirable for new business owners because it is, of course, subject to double taxation — first when the business is taxed, and again when the shareholder-owners are taxed.

Further, the client will be required to file a Form 5500 annually. Because of the specific structure, in which the plan itself owns the business through company investments, the exception for “one participant plans” does not apply.

If the client hires employees who are then eligible to participate in the plan, the client must also be careful to comply with IRS nondiscrimination rules. For example, the client could run into problems if the plan is amended so that other non-highly compensated employees are prohibited from buying company stock.

The client may also wish to conduct a bona fide appraisal at the time of funding to avoid any questions about valuation. Valuation-related prohibited transaction issues typically arise if the assets that are genuinely needed to “start” the business aren’t accounted for in determining the value of the company stock.

Conclusion

Clients should pay close attention to the IRS rules before engaging in any startup funding transactions with their retirement assets — and should make sure that they’ve received competent tax and legal advice that is custom-tailored to their situation.

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