Can one really use their retirement funds to start a business? Often people believe this is just too good to be true. The answer is yes – however when it comes to using 401K or other retirement funds to start of finance a business, there are a number of IRS and Internal Revenue Code rules that must be reviewed. In general, the IRS allows one to use their retirement funds to invest in a business that they or any disqualified person will not be directly or indirectly involved in. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the 401(k) Plan participant, any ancestors or lineal descendants of the 401(k) plan participant, and entities in which the 401(k) plan participant holds a controlling equity or management interest. However, the prohibited transaction rules under Internal Revenue Code Section 4975 prohibit an individual to use their retirement funds to invest in a business they will be involved personally. Internal Revenue Code Section 4975(c)(1)(d) outlines that a transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan is treated as a prohibited transaction. Thus, an individual is not permitted to transfer retirement funds to a business he or she is personally involved in as that would be treated as a transfer of the income or assets of the retirement account to a disqualified person (IRA holder’s personal business).
There is really only one safe and cost effective way to use 401(k) or IRA funds to start a business without tax or penalty – the Solo 401(k) Plan loan. Internal Revenue Code Section 72(p) allows a Solo 401K Plan participant to take a loan from his or her 401K Plan so as long as it is permitted pursuant to the business’s 401K Plan documents.
A solo 401k loan is permitted at any time using the accumulated balance of the solo 401k as collateral for the loan. A Solo 401(k) participant can borrow up to either $50,000 or 50% of their account value – whichever is less. This loan has to be repaid over an amortization schedule of 5 years or less with payment frequency no less than quarterly. The Solo 401K Plan loan can be used for any purpose, including the investment in a business that you will be personally involved in and receive a salary from. The lowest interest rate that can be used for the Solo 401(k) Plan loan is the Prime interest rate as per the Wall Street Journal, which as of March 4, 2012 is 3.25%. The IRS does not restrict the use of the funds, the only limitation involved the re-payment of the loan proceeds. Using a Solo 401K loan to purchase a business offers several advantages. Firstly, you will have tax-free access to your retirement funds so you can use the funds to invest in a new business or finance an active business. Secondly, the loan is taken from your 401K plan so you will be paying your plan back not a bank or credit card company allowing you to increase your 401(k) plan while accessing your retirement funds tax-free.
If you are self-employed and have retirement funds, then the Solo 401k Plan is an ideal structure for starting a new business or financing an existing business.