Tax-free withdrawals make Roth IRAs a compelling option for business owners as a unique method to fund new businesses. But this also comes with potential disadvantages to consider, including penalties, before taking such a leap. Below, we’ll go over funding your business with a Roth IRA and weigh the pros and cons.
Can You Fund a Business With Your Roth IRA?
A Roth IRA is an individual retirement account funded with after-tax dollars that lead to qualified, tax-free withdrawals. “I still see more Gen-Y people or baby boomers who heavily utilize pretax only. In a sense, there is a trade-off; you have to be willing to forego the tax break today,” said Tess Zigo, financial advisor at Chicago-based firm LPL Financial, in an email to The Balance. Even with the delayed tax break, starting a Roth IRA is a popular option among those earning taxable compensation and meeting the modified adjusted gross income (MAGI) requirements. The IRS shares specific mandates around what a qualified withdrawal means, and those include:
Roth IRA account is at least five years old.You’re at least 59 1/2 years of age.Funds are going toward the purchase of your first home (up to $10,000).You have become disabled.Funds are distributed to a beneficiary upon the death of the original Roth account holder
How Different IRS Rules Work
You can see why some consider using a Roth IRA to start a business. CFP Scot Hanson at Educators Financial Services, Inc. told The Balance via email, “It’s not common to use a Roth IRA to start a business. [But] you can use one for whatever reason you justify to yourself.” However, this can be a risky undertaking for several reasons. First, the IRS does not consider business funding an exception to qualified distributions. That automatically creates a red-tape area ripe for penalties or taxes. Second, your age and length of account play parts in determining fees or taxes. Different combinations of these IRS rules make for distinct costs. If you’re considering using your Roth IRA to start a business without meeting IRS qualifications, you need to be careful with legality and risk. Be diligent in identifying your use of funds, attempting to remain within your contributed amount, and working with an accountant to follow the correct procedure.
Pros and Cons of Funding Your Business With a Roth IRA
A Roth IRA could be an accessible mode of funding to start your business, especially with advantages such as avoiding loan payments. Yet there are also disadvantages to review, including close inspection by the IRS.
Pros Explained
Wide array of use: Taking out small business loans or grants comes with specific terms on how to use the funds. A top advantage of using your Roth IRA is freely deciding the best way to use the money. A distribution could cover startup costs of a new business, franchise fees, or purchasing fixed assets. Zero loan payments: Business loans or credit cards can eat into your business’s cash flow. Distributions from a Roth IRA are not a loan, nor do they come with monthly payments. You can put this freed cash into business expenses or prior debt repayment. Tax-free on contributions: Another advantage is having access to tax-free distributions from your Roth IRA. You can do this by withdrawing just your contributed amount. Also, you can meet the qualified transaction rules to forgo taxes.
Cons Explained
IRS inspection: The IRS closely inspects tax-advantageous transactions to ensure rules are followed. You may attract attention from the IRS, which could call for an audit at its discretion. If the IRS deems something to be prohibited, you may face further taxes and penalties. Risking your retirement: Most accountants urge you to review alternative funding forms before using your retirement funds. Zigo said, “I’m a fan of using [loans] versus tapping your retirement account. It’s riskier, and if the business fails, your retirement is also at risk. That’s a lot of stress in addition to just running a business.” The more you pull from your Roth IRA, the less you have for retirement and additional earnings. Tax advisor costs: You may likely need to rely on the guidance of a tax advisor when it comes to distributing your Roth IRA. Working with an expert advisor comes with a greater upfront expense, but they may find a new funding path for you. “It may be totally legal to use your Roth IRA for any reason you deem appropriate,” said Hanson. “I advise you to consult with a qualified CFP to review all your options to come up with the best solution for what you are trying to accomplish.”
How To Use a Roth IRA To Start Your Business
You can withdraw contributions from your Roth IRA at any time and with no penalties or taxes. Further, you can withdraw on earnings but may face a 10% withdrawal penalty and taxes on those earnings. The IRS mandates that you file Form 1040 and possibly Form 5329 to identify taxes if you distribute funds before 59 1/2 years of age. You may also “loan” yourself money from your Roth IRA if you need to borrow for a short period. The IRS allows tax-free withdrawals if you roll over the total amount of distribution into the same or another IRA account within 60 days. You can only do this rollover once in any 12-month period. A self-directed Roth IRA, meanwhile, gives you the option to make investments in alternative assets, including real estate, tax lien certificates, and promissory notes. Rollovers for business startups (ROBS) is another way people fund a new business, but a Roth IRA doesn’t allow for this type of transaction. As per IRS guidelines, a Roth IRA can only be rolled over into another Roth IRA. Eligible retirement plans for ROBS include 401(k)s, 403b, and similar.
Alternative Ways To Fund Your Startup
You may find that the penalties and risk attached to using your Roth IRA for business may not be worth it. Here are a few alternatives to review:
SBA loan: The Small Business Administration (SBA) works with lenders to provide low-interest rate, long-term repayment loans based on your funding needs. Family and friend contributions: A form of bootstrapping, soliciting funds for your business from friends and family can help garner small contributions, especially in the startup phase. 401(k) Participant Loan: You may be eligible to take out a loan on your 401(k) account balance and replenish your retirement fund as you make payments.
The Bottom Line
Using your Roth IRA is a viable option to start your business. However, there are major considerations to understand to know if the move is worth it. Depending on potential fees and the risk of using retirement funds, you may find it safer to go with an alternative funding method. Talk openly with your accountant and/or tax advisor to review your case. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
