Starting a new business requires capital, and for many entrepreneurs, that often means relying on personal savings, at least in part. If you have significant retirement savings, you may be asking, “Can I use my IRA or 401(K) to start a business?” 

The short answer: It depends on the type of account and your role in the business.  

In this guide, we’ll explore how you can (and can’t) use an IRA to fund a business, alternative strategies, and distinguish the pros and cons of using retirement funds to start a business. 

Can You Use an IRA to Fund a Business?

If you have a self-directed IRA (SDIRA), you can use funds to invest in a business, including startups. However, there are IRS rules and regulations that limit opportunities. Specifically, your investment in the business can’t constitute a prohibited transaction or self-dealing. 

If you’re considering using SDIRA funds to open a business, here’s what you need to keep in mind: 

• You cannot directly fund your own business. An SDIRA can invest in private companies, but you can’t fund a business that you plan to own, run or otherwise be a part of. The same applies to any disqualified person, including your spouse, children, parents, and grandparents.  
• You cannot personally benefit from the business. For instance, you can’t draw a salary, use the business assets (even as office space), or make decisions on behalf of the company with your SDIRA funds.

In short, you can invest in a business but can’t use your SDIRA to start or fund your own. 

Rules for Funding a Business with a Self-Directed IRA

If you want to use your IRA funds to invest in a business, you must open a self-directed IRA. This type of account allows you to invest in a range of alternative assets, including LLCs and private equity, that aren’t permitted in standard IRAs.  

Even though SDIRAs expand your investment options, it’s important to note that there are several rules that govern SDIRA investments. If you’re considering funding a business with an SDIRA, you must keep the following rules in mind:

• You cannot directly fund your own business. An SDIRA can invest in private companies, but you can’t fund a business that you plan to own, run or otherwise be a part of. The same applies to any disqualified person, including your spouse, children, parents, and grandparents.  
• You cannot personally benefit from the business. For instance, you can’t draw a salary, use the business assets (even as office space) or make decisions on behalf of the company with your SDIRA funds.
• Work with a custodian. You must open an SDIRA with an IRS-approved custodian. Your custodian generally oversees account administration, though they won’t provide investment insights or help you make related decisions. 

In short, you can invest in a business but can’t use your SDIRA to start or fund your own. 

How to Take a Loan from a 401(k)

If you want to invest in a business but can’t or don’t want to use your IRA funds, you can often take a loan from your 401(k), if it is available. 

If you plan to use a 401(k) to finance your business, keep the following in mind:

• Though rules can vary by plan, you can often borrow up to 50% of your vested balance, or $50,000, whichever is less. 
• Loans do accrue interest, but the interest is paid back to your account. 
• There’s no credit check, and the loan is not reported to credit agencies. 
• No taxes or penalties are applied as long as the loan is paid back as outlined in your agreement.

Remember that if you are using a 401(k) issued by your employer, the loan balance may be considered a distribution if you leave the company. In that case, you may owe a 10% early withdrawal penalty if you’re under the age of 59 ½. 

Further, it’s always wise to consider how the loan may impact your long-term investment goals. Taking a loan from your 401(k) means you’ll reduce your retirement savings until the loan is repaid, and you will also lose out on any interest that would have otherwise accumulated. 

As such, always weigh the pros and cons of taking out a 401(k) loan and review your other financing options. 

Using a Rollover for Business Startups (ROBS) Strategy

A rollover for business startups (ROBS) offers another method for using retirement funds as a way to start a business. When structured properly, this strategy lets you use your 401(k) or traditional IRA to fund your business without taxes or penalties. 

To use a ROBS, follow these steps:

1. Form a C Corporation.
2. Set up a new 401(k) plan for the corporation. 
3. Roll your existing retirement funds into the new 401(k)
4. Use the new 401(k) to buy stocks in the corporation, providing capital to the business venture. 

Once you purchase stocks, you can use the resulting funds to start the business or pay for startup costs.  Unlike SDIRA funding, a ROBS strategy allows you to be actively involved in the business and draw a salary without breaking IRS prohibited transaction rules. 

The key to successfully using a ROBS approach is to ensure that you correctly set up the corporation, maintain the qualified retirement plan for your business, and operate within Employee Retirement Income Security Act (ERISA) guidelines. As such, it’s best to work with a tax advisor or financial expert who can ensure your account is in compliance. 

Should I Cash Out My Retirement Plan to Start a Business (pros and cons)

If a 401(k) loan or ROBS approach isn’t on the table, does it make sense to cash out your retirement account to start a business? The answer primarily depends on your unique circumstances and overall financial picture. However, these pros and cons may help you make the best decision based on your needs.  

Pros

• You gain full control of your funds.
• You can use the funds for any business expense. 
• You won’t need to worry about repaying a loan. 

Cons

• Depending on your account type, the withdrawal may be subject to income taxes. 
• If you’re under 59 ½, withdrawals typically incur a 10% penalty (Note: If using a Roth account, only earnings are penalized, as long as the account has been open for 5 years.).
• You lose tax-free growth and compound interest.
• You risk your financial security in retirement. 

FAQs

What is a Rollover for Business Startups (ROBS), and how does it work?

ROBS is a legal strategy that allows you to use retirement funds from a traditional IRA or 401(k) to fund a new business without triggering taxes or penalties. 

It involves forming a C Corporation, setting up a 401(k) plan, rolling funds into it, and having the plan purchase stock in the corporation. The corporation then uses the capital to operate. This strategy allows you to be an employee and draw a salary, but you must follow IRS and ERISA compliance guidelines.

What are the risks of using my retirement savings to start a business?

The biggest risk is that you may lose your retirement savings if the business fails. Additionally, if the transaction is structured improperly (especially with SDIRAs), you could face penalties and taxes. You’ll also lose out on tax-advantaged growth while funds would have been in the account. Finally, if your business struggles, rebuilding your retirement nest egg may be difficult.

How long do I have to repay a 401(k) loan used for business purposes?

Typically, 401(k) loans must be repaid within five years, with payments made at least quarterly. Keep in mind that if you leave your job, the outstanding balance is usually due in full shortly after separation; otherwise, it’s treated as a distribution and taxed.