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.
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 retirement funds to fund a startup business.
Entrepreneurs have long drawn on their retirement savings including IRAs, SEP accounts and 401Ks to fund a business startup or expand an existing business. It makes sense to them because they 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.
No. 1: The financial safety net. Let’s start with a worst-case scenario. If you have to file personal bankruptcy, your pension, 401(k) and IRA savings accounts cannot be seized by business creditors. Of note, balances in IRAs (Roth and traditional) are generally protected up to $1 million from 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 for interim living expenses.
No. 2: Costly 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 the holding requirements.)
What's more, if you withdraw funds from a 401K retirement savings plan, many employers will withhold 20% of the amount being withdrawn. That’s expensive business funding. You might do better with a back alley loan shark.
No. 3: Lost 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.
No. 4: Self-directed IRAs. Whenever I talk or write about the risks of using retirement assets to fund business needs, I can always count on some angry flame mail from financial advisors who make their living by charging big fees to help business owners tap self-directed IRAs for business purposes. Their brochures say that funding business needs through self-directed IRAs is “risk free.” But what they don’t tell 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-direct IRAs they could face IRS penalties.
No. 5: Investment diversification. Concentrating retirement savings in a privately-held startup business defies all expert guidance from money managers 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 – but no more.
Most retirement accounts are nurtured over decades with the help of employer matching programs and tax deferral advantages. It’s difficult to replace money.
There are business funding alternatives that can reduce investment risks to business owners. It’s just a matter of not waiting until a crisis to learn about viable funding options.
Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship. She is the founder of www.takecommand.org, a community service organization that boasts of offering the largest centralized database of startup and small business funding sources in the U.S. Ask Susan your questions at firstname.lastname@example.org