Did you use 401(k) funds to start your business, or are you tapping into your retirement to get you business through the current credit crisis? BusinessWeek recently drew attention to a possible trap: The IRS is starting to pay more attention to entrepreneurs who finance their businesses using money from their 401(k) funds.
Here’s how such moves typically work: A business owner creates a new corporation, sets up a 401(k) plan for it and moves his or her 401(k) monies into the new plan. The money is used to buy shares in the business, giving it an infusion of capital but still retaining the tax advantages of the 401(k).
Monika Templeman, acting director of employee plans at the IRS, told BusinessWeek that the process “is open to abuse.” If the entrepreneur’s 401(k) funds weren’t rolled over in this fashion, but just withdrawn, the business owner would be subject to income taxes, as well as penalties of 10 percent of early withdrawal if he or she is under age 59 ½.
Templeman says the IRS has seen money used to buy stock whose valuation was questionable or even to buy personal assets such as cars.
The rollover strategy has grown in popularity during the credit crisis; BusinessWeek says some 4,000 people are expected to use the tactic this year. Typically, the transaction involves $100,000 to $200,000 in retirement funds. Financial advisers charge clients an average of $5,000 for the paperwork, plus annual fees of about $1,000 to manage the new 401(k). One financial advisor cited compares the fees favorably to the 15 or 20 percent interest rates banks charge on business loans — that is, if you can get a loan.
With the IRS planning increased scrutiny of such plans, it may be a good idea to review your plan with your advisor and your accountant to make sure it’s not raising any red flags. If you do use 401(k) funds to finance your business, make sure the money is put to good use and don’t use it for any expense for which you can’t make a clear business case.
The IRS website has lots of resources that can help your accountant and advisor clarify the issues. A closer look at the issues with these plans can be found in “Guidelines Regarding Rollovers as Business Startups (ROBS).” This publication is for IRS agents, so it’s pretty dense, but will give you some insights into the issues with the rollover concept.