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Using a 401(k) to Start a Business – Is this Legal?

401(k) to Start a Business

Is it legal to start a business using your 401(k) retirement funds? The answer to that is, yes. However, there are a few obstacles using your 401(k) or other retirement funds to start of finance a business. There are a number of IRS (Internal Revenue Service) and Internal Revenue Code rules that that you absolutely must review. In general, the IRS allows an individual to use his or her retirement funds to invest in a business that he or any disqualified person has no direct or indirect involvement 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:

  1. The 401(k) Plan participant
  2. Any ancestors or lineal descendants of the 401(k) plan participant
  3. Entities in which the 401(k) plan participant holds a controlling equity or management interest

The prohibited transaction rules under Internal Revenue Code Section 4975 disallows people to invest in a business they will be personally involved in. Additionally, Internal Revenue Code Section 4975(c)(1)(d) outlines that a transfer to a disqualified person, use by a disqualified person and that benefits a disqualified person is a prohibited transaction. Furthermore, as an IRA (Individual Retirement Account) holder, you can’t transfer your IRA funds to a business you are personally involved in. The reason is, that transaction will be treated as a transfer of the income or assets of the IRA to a disqualified person (in this case, the IRA holder’s personal business).

Using a 401(k) to Start a Business

So how can you use your 401(k) Plan funds to buy or finance a business?

There is really only one way to use your 401(k) or Individual Retirement Account to fund or start a business without tax or penalty. The structure is the Rollover for Business Startups (ROBS).  It involves the formation of a C Corporation (an entity that is taxed separately from its owners) and the adoption of a 401(k) qualified plan. Your existing retirement funds will then roll into the newly adopted 401(k) Plan tax-free.

The 401(k) Plan will then purchase the stock of the new corporation. The new corporation will then use those funds to purchase a new business or franchise tax-free!

The legality of the structure centers on an exemption in the Internal Revenue Code, which exempts the purchase of “qualifying employer securities” as a prohibited transaction pursuant to IRS Code Section 4975(d)(13). “Qualifying Employer Securities” allows you to invest in and operate a business with the use of your retirement funds. The term “qualifying employer security” includes an employer security, which is stock of a “C” Corporation.

Benefits of the ROBS 401(k) Solution

The advantages of using the ROBS 401(k) Solution is that you can use your IRA or 401(k) to buy a business tax and penalty free! For example, if a new business buyer has $150,000 in a 401(k) or IRA account and takes an early distribution, that will trigger the following taxable events: a 20% mandatory hold-back, Federal (and state) income taxes (at higher tax rates) and a 10% early withdrawal penalty. This could easily be a $50,000 tax bite. With the Rollover for Business Startups (ROBS), a business owner can get the down payment for his new business or help finance an existing business without owing any money to the IRS. Plus, the Business will now have a 401(k) Plan available for its employees to contribute to.

Using a 401(k) to start a business is a smart idea because you can now invest in yourself. This solution allows you to utilize your funds to buy a new or existing business or franchise tax and penalty free while being able to earn a reasonable salary from the business. Again, you can use your 401(k) to start a business, but only through the ROBS solution. You may know this as our previous name, the Business Acquisition Solution. ROBS is the only IRS approved structure for using your IRA or 401(k) plan funds to buy or finance a business you will be actively involved in. If you have recently left a job or are looking for a new opportunity, then why not invest your retirement funds in yourself rather than Wall Street!

More Resources

We encourage you to review our Rollover for Business Startups (ROBS) pages. They will help you better understand how to use your 401(k) to start a business.

  1. ROBS Solution – How Can I Benefit
  2. ROBS Solution – How it Works
  3. 401(k) Plan Contribution Rules and Limits
  4. ROBS Prohibited Transaction Rules
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Posted in 401(k), Business Acquisition Solution

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