Self-Directed IRAs vs. Self-Directed 401(k)s: Which Is Best for Business Funding?

Leveraging existing retirement funds to start a new business is an incredibly useful way to accelerate access to funds. 

Entrepreneurs have several options when it comes to which funds to use, and it is important to find the solution that works best for you and your business. There are distinct differences between using 401(k) funds or an IRA in a self-directed funding strategy. Understanding these differences will help you make the right choice for financing your business.

 When it comes to self-directed IRAs vs. self-directed 401(k)s, which is best for business funding?

Background on Self-Directed Business Financing 

Congress established IRAs by the Employee Retirement Income Security Act of 1974 (ERISA) and in 1978 included a provision that was added to the Internal Revenue Code (IRC) - Section 401(k). These plans are designed to help individuals save for retirement or needed expenses. Both plan types can be used for alternative investments – including business financing, real estate, and private company shares. 

Both investment types are subject to federal taxes at various points and withdrawal actions.  

However, despite those broad similarities, there are very different rules for using the different financing types for a new business. 

How Self-Directed IRA Investment Works 

If you withdraw funds from an existing IRA account for investing in a business, you can take advantage of having checkbook control over your assets. You can use a self-directed IRA to establish an LLC or C corporation for your business.  

As the owner, you can make decisions broadly on where to invest your money. However, when it comes to your own business, there are strict limitations on the use of funds. For example, you may not be directly involved in the company in any capacity, including taking a paycheck. The investment must be passive. 

As the business owner, you cannot personally guarantee a business loan using your transferred IRA assets. If your business is established as a C corporation, it may issue stock, but not to you as the owner. 

What’s more, if any prohibited transactions are identified related to the use of the IRA funds, the IRA loses its tax-deferred status. You’ll have to pay taxes on the withdrawal, retroactive to the date the note was guaranteed. 


How Self-Directed 401(k) Investment Works 

The self-directed 401(k), also known as a Rollover as Business Start-Ups (ROBS) strategy, offers far greater flexibility to a business owner. Using your 401(k) for startup costs is a simple process:

  1. Establish your new business as a C corporation, which allows the new business to issue stock and have a retirement plan. 
  2. Create a retirement plan for your new company. 
  3. Transfer funds from your existing 401(k) account to the new company’s new retirement plan. 
  4. Have the new company issue stock. 
  5. Have the new retirement fund purchase the new company stock.

What does this series of transactions do? It lets the stock issuer (you) reap the benefits of the stock sale with cash that can be used to fuel your business launch. The legal provisions allow you to work at the company, guarantee a business loan with the assets, and draw a salary. 

Benetrends pioneered the Rollover as Business Start-Ups (ROBS) strategy. For decades, the company has helped business owners use ROBS to achieve their entrepreneurial dreams. To learn more,  download The Definitive Guide to 401(k)/ROBS Business Funding

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