Is it ever OK to use your retirement savings to fund a business? At one time, tapping into an IRA or 401(k) might have been something you would never have considered. But with a slow economy and clients paying more slowly and capital hard to come by, some have started to think differently.
Seventy-four percent of small-business owners recently surveyed by consulting firm Information Strategies said they would use money from their 401(k) to maintain cash flow or to expand their businesses, Business Week reports.
I find that worrisome — especially if you are over the age of 40.
Let’s look at 3 situations where a 401(k) or IRA might be used for business purposes:
(1) Cashing out a 401(k) or IRA to start or buy a business
I know people who have done this. Sometimes it works out; sometimes it doesn’t. If you are going to close out a 401(k) or IRA account to put it into a new business, you will incur penalties and owe tax. And if the business doesn’t work out, you could lose the net amount you pulled out, to boot. Make sure you understand the risks involved with starting a business. For example, failure rates for new businesses are high.
Discuss the move with your spouse, too, because you also are putting your spouse’s financial future up in the air. And consider your own personal circumstances. This tends to be a less risky option for younger people. Time can be your friend or your enemy, depending on your age. If you have more working years ahead of you than behind you, you still have time to accumulate funds for retirement later on. If you are past the age of 40, however, retirement time may arrive before your bank balance is ready for it.
(2) Closing a 401(k) or taking out a loan against it, to meet your operating expenses
This use of a 401(k) — to keep an existing business afloat — can get particularly dicey. CPA Sandy Abalos, quoted in Business Week, says she sees more and more small-business owners using retirement money– something she never used to see. “Every single one of those I’ve seen use it all ended up in bankruptcy,” cautions Abalos, who says you should never use retirement funds to prop up a business that’s losing money. If you are considering tapping retirement funds, she recommends having your accountant honestly assess your business’s chances for survival — because if you’re desperate to keep the business afloat, you might not be making the smartest choices.
Your business doesn’t have to be in desperate straits to consider tapping retirement money. Other entrepreneurs are using these funds as a stopgap solution when the overall business is strong, but a few clients are slow to pay. It’s possible to borrow from an IRA without penalties as long as you pay it back within 60 days. Of course, you need to be sure the client is going to pay you within that time frame. And remember, a lot can change in 60 days, and you may not be able to pay the retirement account back.
(3) Investing a self-directed retirement account into your business
A far more complex option some entrepreneurs use is moving money from their retirement funds to a firm that enables self-directed investments — so you can invest it in your own business instead. Pensco, Guidant Financial and Trust Administration Services are among the companies that can help you do this.
However, the IRS frowns upon such arrangements, calling them a “scheme” and referring to them as “ROBS” (that should tell you something right there!) in an advisory issued by the IRS in late 2008. (See the IRS advisory here — PDF file.)
All I will say about this option is that it’s fraught with legal pitfalls if you do not follow the IRS rules and regs to a T. As this article by the Barefoot Accountant on AccountingWeb points out:
“The consequences of entering into any prohibited transactions and of carelessly setting up a ROBS are staggering penalties of 110% or more of the amounts involved in the transactions or the roll over itself.”
Plus, you could be flagging yourself for a tax audit. Check with your accountant and/or attorney before going the self-directed retirement route.
Have you ever tapped retirement funds for business purposes, either for starting up or to keep your business afloat? What has your experience been?
If you haven’t used a retirement fund, would you consider doing so?