How To Use Your 401k To Buy a Business

You can take money out of your 401k with no penalty at any age to buy a business. This is done by first becoming a business owner, then opening a new 401k with a Custodian who will allow this. (Very few do). Then you roll your IRA to your new 401k. Next the 401k purchases shares of stock in the business that you are trying to buy. You do not get to actually handle the cash from your 401k, instead the Custodian transfers cash from your 401k to the seller of the business.

The Problem

There is a big potential problem: the tax code does not allow retirement accounts to lend money to the account owner (except for a 60 day IRA temporary withdrawal or a 401k maximum loan of $50,000). So in theory the newly acquired business could not loan it money to the 401k owner not could the 401k owner loan funds from his taxable account to the business. This could create catastrophic cash flow crisis because it may be hard for a small business to qualify for a bank loan and if the business needed cash and the owner was not allowed to loan cash to his own company then the business could fail resulting in a ruined 401k.

So I can’t recommend buying a business with a 401k (that is held inside of a 401k), unless you are simply getting a $50,000 loan from your 401k. If you get a 401k loan be sure the payments, amortized over five years, are affordable.

A similar idea is to buy rental real estate with an IRA. This bad because if the property needed extra cash for improvements or operating expenses, etc. then the owner can’t loan money to the IRA and it may not be possible for an IRA to qualify for a bank loan. Further, both IRA’s and 401k’s are not supposed to borrow money and if they do that triggers unrelated business taxable income (UBTI).

If you decide to pursue this type of investing then it would be important to have a huge surplus of cash left over in the 401k or IRA to pay for emergencies.

Also if you buy a business or rental real estate inside of an IRA or 401k it is urgent to get tax advice from a very experienced CPA or tax attorney. Avoid getting advice from someone who is promoting these things and instead find a tax expert who is somewhat neutral and skeptical about this matter so that he can be objective.

Beware the Potential Penalties

There are serious IRS penalties for making improper investments inside of a tax-deferred or tax-free retirement account. By “improper” that could mean doing something which the IRS deems is loaning money back to the account owner by indirect methods such as having the business buy something from the owner. For example, if an IRA account owned a business and the business bought equipment from the IRA account owner’s personal taxable account that is prohibited and penalties for improper withdrawal and failure to disclose to the IRS would apply. Then, the IRS would deem that to be a taxable withdrawal with early withdrawal penalties and penalties for making tax errors.

Another tax problem: what if the 401k sells the business or a rental property at a profit? Then the long term gain would be treated as ordinary income, not the lower long term capital gains rate. If an asset is owned outside of a retirement account and it appreciates, and is never sold until the owner dies, then the basis is stepped-up and thus its sale would be free of capital gains tax. By contrast, the 401k when disbursed to the owner pays out only ordinary income and has no basis step-up at death.

Basically it is not a good idea to put your retirement account at risk with the purchase of a small business inside of the retirement account. Small businesses are much riskier than publicly traded companies and small cap publicly traded companies are riskier than large Fortune 500 firms. Further, it is important to diversify. The purchase of a business in a 401K would probably use up all of the funds in the 401k resulting in a dangerously undiversified account with a concentrated investment in a ultramicrocap stock. 80% of small businesses fail; even franchises have a high failure rate, so please don’t buy a business with your IRA or 401k retirement account.

About the author

Don Martin, CFP®

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