I love helping entrepreneurs set purposeful goals for their new companies. And because they are often doing things that are new to them, they need encouragement too. This is why I frequently write, “You can do it” at the end of many of my columns.
However, there are a few occasions when I emphatically say to business owners, “Don’t do it!” I don’t have many absolutes in business building, but I do consistently discourage entrepreneurs from using precious retirement funds to launch a startup business.
It seems logical to tap IRA and 401(k) retirement accounts to fund a business because owners envision that their businesses will be so successful that they will be able to retire on their company’s profits.
Another reason why entrepreneurs tap retirement savings is simply because it’s fast and easy. In contrast, lenders and investors demand business plans, projections, good credit scores and accountability.
So why am I so negative about using retirement accounts to fund emerging businesses? The devil is in the details…
Loss of a financial safety net
Let’s start with a worst case scenario. If you have to file personal bankruptcy, most pension, 401(k) and IRA savings accounts cannot be seized by business creditors. By keeping your retirement savings in place you won’t likely ever say that you lost “everything” in a financial crisis. You have “something” to fall back on to take steps forward again.
Paying extra penalties
If you directly withdraw funds from a traditional IRA account before age 59 ½, you will likely owe a 10% penalty on the taxable portion of the withdrawal plus income tax. (Roth IRA accounts let you deposit after tax money and make tax-free withdrawals if you meet certain requirements.)
What’s more, if you withdraw funds from a 401(k) retirement savings plan, many employers will withhold 20% of the amount being withdrawn. That’s expensive business funding!
Loss of tax advantages
A third reason to keep retirement funds in place – again another worst-case scenario – is the potential to lose the cash value of some tax savings. When you lose money in a retirement account, you can’t offset those investment losses against current or future investment gains for tax purposes. It’s a fine point for sure, but better to be aware of it before deciding which savings accounts will be used for entrepreneurial endeavors.
Dangers of self-directed IRAs
Whenever I talk or write about the risks of using retirement assets to fund startup business needs, I can always count on some angry flame mail from financial advisors who make their living by administering loans to business owners through their self-directed IRAs.
Their brochures say that funding business needs through self-directed IRAs is “risk free.” But what they don’t tell startup business owners is many banks won’t lend money against assets (company stock, real estate, equipment, etc.) that are held in retirement accounts because they can’t take control of the collateral in bankruptcy court. Further, if business owners can’t pay back loans to self-directed IRAs they could face some stiff IRS penalties.
Loss of investment diversification
Concentrating retirement savings in a privately held startup business defies all expert guidance from personal finance experts to maintain a highly diversified, low-risk retirement portfolio. At best, experts recommend that Americans invest no more than 5% of retirement savings in “small cap” companies, which is exactly what your startup would be considered.