Investing in a Roth IRA is a beneficial method of building retirement funds and setting up your future, whether you are a business owner, salaried worker, or stay-at-home spouse. The individual retirement plan functions similarly to a traditional IRA with one key difference: Qualified distributions can be tax-free when meeting certain IRS requirements.
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.
- A Roth IRA is an individual retirement account funded by post-tax dollars and allows for some tax-free distributions.
- Contributions you place in a Roth IRA can be withdrawn tax-free at any time, but this is different from account earnings that may be taxed upon distribution.
- You can withdraw from a Roth IRA to start a business, although you need to be cautious about qualifications and red flags.
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.
A reform was proposed toward the end of 2021 that could create strict regulations around individuals with taxable income over $400,000. They would have a $20 million cap on their Roth IRAs and need to withdraw anything over that limit, subjecting it to considerable taxes. The reform has not been passed by Congress as of Q1 2022.
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
There is an important distinction between contributions and account earnings. You can take out the amount you’ve contributed to a Roth IRA without penalty or taxes, regardless of your age or years holding the account. However, taxes and penalties begin when withdrawing account earnings.
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.
|Your Age||Account Age||Taxes||Penalties|
|At least 59 1/2||At least five years||None||None|
|At least 59 1/2||Less than five years||On earnings||None|
|Younger than 59 1/2||At least five years||On earnings*||10% withdrawal penalty*|
|Younger than 59 1/2||Less than five years||On earnings||10% withdrawal penalty*|
*Can avoid with qualified reason/exception
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.
Wide array of uses
Zero loan payments
Tax-free on contributions
Risking your retirement
Tax advisor costs
- 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.
- 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.
You can also invest in businesses within a self-directed Roth IRA, either in their entirety or in part. For example, a self-directed IRA can choose to invest in LLCs, but the LLC needs to abide by IRS rules.
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.
Frequently Asked Questions (FAQs)
When can you take money out of a Roth IRA?
You can take out distributions from your Roth IRA at any time, although the IRS doesn’t require you to do so. However, taking out on earnings could come with a 10% withdrawal penalty before age 59 1/2 and taxes depending on whether it's a qualified distribution.
How else can you use a Roth IRA?
In terms of using your retirement fund to start your business, Hanson said, “You might be able to use an IRA or Roth IRA as collateral to get a loan. A loan to start your business may be a much better solution versus a distribution.”
Is a Roth IRA or a traditional IRA better?
This answer is unique to all, although in an email to The Balance, CFP Patrick Durst of Front Range Financial said, “IRAs include a business partner—the IRS. Do you want to have a business partner along for your full retirement with the option to change tax rates and code? With a Roth IRA…you buy yourself freedom from whatever taxes may be in the future, giving you control.”
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IRA Financial. “Buying a Business With Retirement Funds.”