Can I Use My IRA to Invest in a Startup?
IRS rules do permit Individual Retirement Accounts (IRAs) to invest in start-up businesses; however, there are important considerations that need to be understood first. These include Prohibited Transaction rules which restrict who may receive compensation from such an IRA-owned business as well as how an entrepreneur may “sweat equity” into it.
Investment in private companies with promising growth potential is attractive to many investors. But it is crucial that they understand the limitations associated with their IRA investments as well as how to avoid prohibited transactions or UBTI violations.
1. Taxes
With the odds already stacked against any startup, an investment from an IRA investor can significantly improve their odds. Furthermore, using retirement funds for investments in a startup may trigger unrelated business taxable income (UBTI).
UBTI can arise when investing in pass-through business entities owned by Disqualified Persons such as an IRA owner and his or her lineal family members, such as LLCs that pass taxation. To prevent UBTI from happening, an IRA should invest in nonpass-through companies or seek investments from individuals who are not considered Disqualified Persons.
Even with the risk of UBTI, it is possible to use an IRA to invest in startups through ROBS. For instance, if the founder of the startup is self-employed he could set up his own solo 401k plan and borrow from it to invest in his business without being subject to UBTI rules. As this transaction can be complex it’s wise to consult an experienced professional when engaging in such complex transactions.
2. Minimum Required Distributions
The Protecting Americans from Tax Hikes Act of 2015 makes it much harder for an IRA to invest in startup companies using tax-deferred dollars. Under this act, certain pretax retirement accounts – traditional IRAs and 401(k) plans – must make minimum required distributions (MRD), which are calculated based on all assets held within an account including more illiquid investments like startups with asymmetrical returns.
To be compliant, an IRA owner would have to withdraw or transfer his investments prior to MRDs starting, which can cause issues as the startup could run out of money and no longer pay employees or vendors. Furthermore, direct payments would violate IRS rules regarding prohibited transactions and unbudgeted business tax expenditures (UBTIs). Finally, disqualified persons such as spouses, lineal relatives or certain financial or business relationships cannot receive funds from an IRA account holder’s IRA account.
3. Illiquid Investments
Investment in illiquid assets such as startups can present certain risks. They may be difficult to convert back into cash without incurring losses in value; additionally, lockup periods for these types of investments could take years before any return is realized – potentially leaving your return unseen for years.
As startup businesses are private entities, they’re not required to meet the same reporting standards as public-listed stocks; making it more challenging for investors and analysts alike to assess whether the company has been fairly valued.
IRS restrictions prevent IRA investments in businesses owned by you or other disqualified persons for more than 50%, which could present problems if you plan to play an active role in decision-making or leadership positions. Luckily, most startups are founded by small teams or sole entrepreneurs, which allows you to bypass this rule; although this may limit potential returns.
4. Special Custodians
Mainstream IRA custodians like Fidelity and Schwab don’t provide services designed to manage illiquid assets such as startups. Instead, investors must use specialized custodial firms like Millennium or Pensco that have experience handling these types of investments; though their fees may be more costly they also offer greater investment options.
When investing in startups through an IRA, investors must do their homework and research thoroughly. Furthermore, it’s wise to get independent valuations as investments can often be hard to value accurately without professional assistance; doing so reduces fraud risks considerably.
Self-directed IRAs allow owners to invest in a range of assets, such as startups and real estate. But investors still must be wary of prohibited transactions and other issues; an experienced advisor can assist in navigating these obstacles to avoid potential issues; they may even set up ROBS arrangements to enable startups raise capital from retirement accounts.
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