Can I Invest in My Own Business With 401K Money?

24 Replies

Hello all,

As part of my Roth 401K plan I am able to use a portion of my account balance as a self directed investment account. I know I am able to invest that money directly in real estate with the caveat that all profits go back into the retirement account as earnings. This is of course good, but then all my profits are tied up in the investment account and I can't access without penalty. Would it be possible to invest this 401K money in my rehabbing company which will then pay a set interest rate to the 401K. I would essentially be my own hard money lender.

So, am I crazy or is this illegal? I'm guessing if there is a legal question it would be due to my proximity to the investment?

Tom

From the way I understand the system, you cannot do that. Im sure other folks on BP will have more knowledge but I think if the money goes directly into an account which you solely control, that's a violation

This is not legal. Your retirement funds cannot directly benefit you personally and you personally cannot directly benefit your retirement investments.

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With a self-directed IRA, you can invest in real estate, stocks, mortgages, franchises, partnerships, precious metals, private equity and tax liens. You could roll over your 401K to an IRA and invest in real estate. I've used Pensco before (pensco.com).

My understanding is that you could do a ROBS (Rollover as Business Startup) using your 401k money to fund your rehab business. There are many hoops and pitfalls for the unwary, so talk to an expert. Setup and administration is also not cheap, since you are essentially setting up a retirement plan for your business funded with your 401k money, so may not be worthwhile depending on how much money you are planning to use.

Originally posted by @Tom Scott :
So, I would only be able to invest in a legal entity that I do not control?

That you don't control and that doesn't benefit you in any way.

For example, technically you can't invest your 401k money into a friend's McDonalds franchise and then get free fries for life... :)

Tom, definitely need to talk to an expert. Google "Self Directed IRA Rollover" and find a reputable company... give them a call and find out what they can do. If they control the IRA and distribution, you are protected from accedintaly doing anything illegal.

Tom, what you described is a 'prohibited transaction'. IRS does not allow any disqualified person to conduct business with your retirement plan.

An alternative to this can be taking a personal loan form your 401k (it it has this option available). The loan must be paid back within 5 years and can be used for anything you wish. You can invest the money in a rehab that you personally doing, pay back the loan plus interest and keep the rest as your personal profit. Of course you will be taxed on all the gains unlike if you did that inside of a 401k.

Originally posted by Account Closed:
My understanding is that you could do a ROBS (Rollover as Business Startup) using your 401k money to fund your rehab business.

Yes, you can use a ROBS for this. I did this back in 2009 and didn't sleep well for two years knowing the IRS wasn't too keen on many of the ROBS providers and the way they were using a loophole to avoid taxes on non-retirement income (they're the ones that coined the phrase "ROBS")...

I was so concerned with my decision to pursue a ROBS that I voluntarily paid to have the IRS audit me (and provide a letter that said I was legally compliant) so I wouldn't have to worry about them eventually cracking down and unexpectedly being audited 5 or 10 years from now when things were less favorable.

Originally posted by @Daniel DiGiacomo :
Tom, definitely need to talk to an expert. Google "Self Directed IRA Rollover" and find a reputable company... give them a call and find out what they can do. If they control the IRA and distribution, you are protected from accedintaly doing anything illegal.

Nope. It's not the responsibility of the SDIRA company to advise you of potential ERISA compliance issues.

For example, if you make an SDIRA loan to a disqualified family member, it's very unlikely the SDIRA company will know that's the case (or care). They'll disburse the money as you direct them to (hence the "self directed")...they won't vet your investments for you.

Originally posted by @J Scott:
I was so concerned with my decision to pursue a ROBS that I voluntarily paid to have the IRS audit me (and provide a letter that said I was legally compliant) so I wouldn't have to worry about them eventually cracking down and unexpectedly being audited 5 or 10 years from now when things were less favorable.

Man, that is some serious integrity (or risk aversion).

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Originally posted by Account Closed:
Originally posted by @J Scott:
I was so concerned with my decision to pursue a ROBS that I voluntarily paid to have the IRS audit me (and provide a letter that said I was legally compliant) so I wouldn't have to worry about them eventually cracking down and unexpectedly being audited 5 or 10 years from now when things were less favorable.

Man, that is some serious integrity (or risk aversion).

Purely risk management...and loss of sleep... :)

I appreciate the information guys. I'm not sure I want the risk of the IRS getting involved in anything I do. I was simply looking at my options to get my first deal underway. I'm not sure I want the hassles that seem to come along with the ROBS route. At this point I think I need to decide whether to get investor dollars or use a 401K loan or a mixture of both. If all goes well I will only need to use either for the first few deals until I get my war chest built up.

Tom

If a SD-IRA custodian knows there is a prohibited transaction taking place, the custodian will most likely distribute the portion of the IRA/Solo(k) involved in the prohibited transaction, which will kick off taxes and penalties.

Furthermore, if a custodian like the one I work for is presented with an asset that's a PT for acceptance, and we see the PT, we will not accept the investment.

Originally posted by @J Scott:
Originally posted by @Daniel DiGiacomo:
Tom, definitely need to talk to an expert. Google "Self Directed IRA Rollover" and find a reputable company... give them a call and find out what they can do. If they control the IRA and distribution, you are protected from accedintaly doing anything illegal.

Nope. It's not the responsibility of the SDIRA company to advise you of potential ERISA compliance issues.

For example, if you make an SDIRA loan to a disqualified family member, it's very unlikely the SDIRA company will know that's the case (or care). They'll disburse the money as you direct them to (hence the "self directed")...they won't vet your investments for you.

J, Thanks for the feedback! Pensco asks a lot of questions, but you're right, I can't imagine they would assume liability for my decisions.

I am going the ROBS route right now, quitting my day job, starting a C-corp, creating a new 401K for the roll-over, etc. I have been consulting with prospective providers, I'll be happy to share the experience as we work through it. I would be taking a huge hit without this option as all my funds are tax-deferred and I'm under 59 1/2 yrs old, so over 35% in tax and penalties. Based on the consultations I've had so far, there isn't a lot of risk involved as long as you actually use the funds for a legitmate business that stimulates the economy, don't use the money for a new swimming pool or fast cars, and keep the new 401K operating after you convert the funds to operating cash. You also have to pay yourself a salary and contribute at least 1% of your salary to the 401K.
Setting the whole thing up costs about $5K up front, plus $800 per year to manage the 401K and file all the necessary annual paperwork. Another $750 to do an annual share valuation to keep the IRS and DOL off your back.
At this point, I'm still pretty ignorant in these matters, but looking forward to a quick education over the next month or two.

ROBS is not a fringe technique. It has been used to start tens of thousands of small businesses, often franchises. In fact, a sizable percentage of all franchises are financed in this manner (particularly after the crash when banks would simply not lend on such enterprises). The IRS has essentially blessed this structure, as long as the rules are followed. The larger/reputable providers state that they have never lost in an IRS audit (Guidant, Benetrends, SDCooper, IRAFinancialGroup) . Here are the advantages from my perspective, as I just went this route.

  • Use your 401k to invest in "active" real estate businesses (rehabbing, home building, property management, wholesaling) without incurring trust tax on your 401k (a 40% rate after active income hits about $12k)
  • Avoid taxes and penalties that would be incurred if the funds were withdrawn from the 401k.
  • The C-Corp can borrow from a bank on highly favorable terms, and the business owner is free to provide a personal guaranty (in this case, the guaranty is not a prohibited transaction)
  • The C-Corp pays you a salary
  • If successful, you can eventually buy out the 401k and convert to an S-Corp, which would be more tax efficient.
  • This may be the only viable way to start a sizable real estate operating business!
Originally posted by @David Beard :

The larger/reputable providers state that they have never lost in an IRS audit (Guidant, Benetrends, SDCooper, IRAFinancialGroup) . Here are the advantages from my perspective, as I just went this route.

That's probably true...none of them have received a negative determination on their structure. That's not the (only) issue, though.

The determination letter the promoter receives just blesses the plan, not the individual implementations of the plan. If I start a ROBS using a template provided by a perfectly compliant promoter, I can still (very easily) run afoul of IRS/DOJ regulation. Additionally, a promoter who receives a favorable determination letter may implement their plans in a way that runs afoul of regulations (despite the favorable determination).

For example, with a ROBS, if you have employees, you must offer every employee an opportunity to invest and profit-share in the plan. If you don't make that offering within some period of time (I believe it's 30 days), you have technically run afoul of ERISA rules. If the plan doesn't do a formal valuation of assets at the end of every year, that may run afoul of requirements. If the promoters charge fees in an illegal manner, that can cause the plan participants to be put at risk. Etc...

Here is a statement issues by the IRS/DOJ a couple years ago that says it better than I can:

http://www.irs.gov/Retirement-Plans/Retirement-News-for-Employers---Fall-2010-Edition---Rollovers-as-Business-Start-Ups-Compliance-Project

My take is that ROBS can be done perfectly legally. But, unless you're an ERISA attorney, or unless you are working under the direct guidance of an ERISA attorney, you won't know if you're breaking the law until it's too late. And the penalties are potentially VERY steep -- you can lose your entire retirement fund, PLUS additional penalties on top of that.

Originally posted by @Joe Kalis :
@Tom Scott - take a look at http://www.benetrends.com/401k-ira-business-funding/the-rainmaker - I have no idea if it's a "ROBS" plan that the others mention, but I've been recently made aware of this and it looks pretty clever.

I'd be interested to know if this is a ROBS plan everyone is speaking of!

Yes, this is a ROBS plan...

As long as you stick with an experienced and reputable provider (that have ERISA, corporate, and tax attorneys on staff, such as the four I listed previously), and follow their clearly delineated guidelines for avoiding prohibited transactions and running the 401k in a nondiscriminatory manner, then I don't view this as a risky technique whatsoever.

Again, I tallked to all four providers that I cited, and all indicate that in those instances where their client plans have been audited (talking about actual audits, not generic letter of determination), that the IRS has taken no adverse actions against their clients, insofar as those clients followed the clear rules. There are also various rules in administering your self-directed checkbook IRAs and 401k's, this is only a bit more complicated and well within the pay grade of most smart folks on here!

I've been impressed by the knowledge base and credentials of attorneys and representatives of these ROBS providers. They've come a long way in the decade since these plans came on the scene, and pretty much have it down pat at this point. Some general rules that they all agree on, that I can think of at the moment:

  • Take a salary only as the company earns revenue.
  • Invest some personal funds in the C-Corp alongside the 401k's funds (can be as little as 1 or 2% of the total investment)
  • Contribute to the 401k from your salary, at least 1%
  • If you have employees in this C-Corp or any other entity that you control (i.e. a so-called control group), don't be discriminatory in running your 401k. There are short cuts and "safe harbor" techniques that you can follow. It's not a minefield, and each of the four providers that I mentioned have ERISA attorneys that provide ongoing support and guidance.
  • Avoid prohibited transactions between the C-Corp and yourself (or a party that is disqualified relative to yourself), as well as between the 401k and yourself
  • Have the business appraised annually, and whenever C-Corp shares are issued or redeemed.