An IRA can be used as a source of capital for a small business. However, it can be complicated and subject to many requirements.
Retirement is one of the most significant financial goals most individuals will strive to achieve in their lifetime. With declining pension plans and questions about the fate of Social Security retirement benefits, many Americans have had to focus on self-funding their retirement plans early on in their working careers.
In addition to employer-sponsored retirement savings vehicles, such as 401(k)s and 403(b)s, anyone who earns an income from an employer or as a self-employed person can save additional funds through an individual retirement account, also known as an IRA.
Although IRAs are meant to provide a tax-benefited way to save toward retirement objectives, many small business owners consider using funds from an IRA to help cover capital expenses for their companies. This is because retirement savings are generally the most significant part of wealth for most individuals, outside of personal real estate.
Additionally, the current rising interest rate environment as well as other factors has made the small business lending environment less affordable for many business owners. While using IRA savings for small business funding is an option in certain scenarios, the strategy is complex and requires an in-depth understanding of the tax benefits – and consequences – of tapping into retirement savings for business needs. They are many better options available for small business owners.
If you don’t think you have any options, here is what you need to know if you are considering using an IRA to lend money to business ventures.
How Do IRAs Work?
IRAs were designed to help individuals save for retirement. The IRA holder can contribute up to the maximum amount each year, currently $5,500 for individuals and $6,500 for those over 50, in a tax-benefited way. Contributions made to a traditional IRA grow on a tax-deferred basis, and there is no obligation to pay taxes until the money is withdrawn in retirement or as an early distribution. Typically, funds in an IRA must stay in the account until age 59 ½ to avoid tax penalties.
The most common IRAs are traditional IRAs, which allow the account holder to invest in a variety of assets, including mutual funds, exchange-traded funds, stocks, bonds, and cash. Another popular IRA is the Roth IRA, which allows account holders to deposit the money after it has been taxed as income for later withdrawal without taxes on the gains.
In recent years, self-directed IRAs have also become a popular option. With a self-directed retirement account, an account holder has more flexibility in what he or she may invest in within the account while maintaining the tax benefits. However, self-directed IRAs come with some restrictions, including prohibited transactions as defined by the IRS. These restrictions include:
- Selling, exchanging or leasing property as a disqualified person
- Lending money or extending credit from the IRA plan
- Furnishing goods, services, or facilities from the IRA
- Borrowing money from an IRA
- Selling property to an IRA
- Using IRA assets as security for a loan
- Buying property for personal use with IRA funds
These prohibited transactions within an IRA may result in a tax penalty. However, for small business owners, there is the ability to borrow from their IRA to lend money to their business ventures.
How Can You Lend Money to Your Small Business?
There are two ways to lend money to a small business from an IRA: through a self-directed individual retirement plan or through a rollover as a business start-up plan (ROBS). Here’s how each works:
Self-directed IRAs and Small Business Funding
There are four steps making up the process of lending to a small business through a self-directed IRA. These steps are as follows:
- Establish a self-directed IRA with a special custodian who understands the rules and regulations surrounding these types of IRA accounts.
- Fund the self-directed IRA through a rollover from an existing IRA, or a 401(k) or 403(b).
- Establish an LLC that is also managed by the IRA account owner.
- Purchase membership units in the LLC directly from the funds held in the self-directed IRA.
This option is only available to individuals with a self-directed IRA who do not have any direct involvement in the business they are funding. If the business you want to lend money to or invest in is your own, consider a ROBS structure.
ROBS and Small Business Funding
With a rollover for business start-up (ROBS) plans, the rules are as follows:
- A C corporation is established.
- The C corp. then establishes a new qualified retirement plan that can invest in private company stock, typically a 401(k).
- Funds from existing IRAs or other employer-sponsored plans may be rolled over into the new C corp’s retirement plan.
- The C corp. plan then invests in the stock of that corporation.
- The C corp. invests in, loans money to, or acquires a new business with the available retirement funds.
In either case of providing funding for a small business with IRA assets, you will likely need the help of a seasoned tax advisor or retirement plan professional. Some tax and financial advisors offer expert advice and guidance in this space and may provide the right set-up as a fiduciary custodian for IRA or retirement plan assets.
If either of these scenarios are an option for you, it is important that you include the assistance of a qualified tax advisor who understands current tax laws as well as potential pitfalls when lending or investing money from an IRA to a small business.
What are the downsides to funding a business with an IRA?
Although there are viable options for funding a business with the help of retirement savings, caveats abound. First, the IRS has strict rules on what is considered a “prohibited transaction” under both self-directed IRA investments and ROBS plans. If misunderstood, both the account owner and the business owner could face serious ramifications.
With self-directed IRAs, the business investment must be passive, meaning the IRA account owner cannot actively participate in the business it is funding. With ROBS, business investors do not face this restriction, but there are other limitations as far as receiving a salary from the business. Ignoring these issues can lead to significant tax penalties for the business owner or IRA owner.
In addition to the potential for costly transactional missteps, IRA funding for a small business also represents a substantial risk. Because IRA savings are often the biggest contributor to a well-funded, comfortable retirement, taking these funds to invest in a business that could fail is a high-risk move. Make sure you understand the strength of the business, including its earnings and growth potential, before depleting your nest egg to invest.
Alternative Sources of Funding for a Small Business
There are alternatives to taking money from a retirement savings plan to help fund a small business. The most common options include:
Small Business Loans
Traditional bank or credit union lending is great when you can get it. However, it is still elusive for many small and medium businesses for any number of reasons. Small business loans are available based on the financials of the business, or the credit history of the business owner. When credit is strong, a small business loan can be obtained for single-digit interest, with predictable repayment schedules and lump-sum funding. However, this may not be an option for small business owners without strong credit.
Merchant Cash Advances
With a merchant cash advance (MCA), a financing company like Zip Capital Group advances your cash in exchange for a percentage of daily credit card and debit card sales, plus a fee. Merchant cash advances can be quick and easy ways to get a business cash advance with no need for collateral, even if you don’t have a great credit score.
Additional features of merchant cash advances include quick access to funds, an easy approval process, can be used for a wide range of business purposes, and willingness to work applicants having bad credit.
Another alternative to using IRA funding for a small business involves personal assets. Many business owners use credit cards, personal loans, home equity, and personal savings to help pay for small business ventures. Unlike IRA savings, personal assets have minimal tax issues and the transfer of funds is more straightforward.
Friends, family members, angel investors, and venture capitalists may be a sound way to raise capital for a business need. Each has its advantages and drawbacks, but getting funding through these sources may come with fewer tax issues and more flexibility than using IRA savings.
Business owners need to review their need for funding and their ability to manage the process of using savings from retirement assets before pursuing a self-directed IRA or a ROBS transfer. Consider alternatives such as a merchant cash advance, or small business loans to these funding sources before making a decision. If an IRA is the best option for lending to a small business, be sure to consult a financial and tax advisor who understands the end goal as well as the requirements of the transaction.
Before considering your IRA, contact us to see if a merchant cash advance is better suited to your needs