People become entrepreneurs because they decide to take control of their own destiny by starting or buying a business. But with this decision comes the very significant problem of getting the small business venture financed. In many cases, the entrepreneur’s investable assets are held primarily in qualified retirement vehicles such as IRAs, pensions and 401(k) plans.
Qualified retirement assets enjoy one or another kind of preferred tax treatment, typically tax deferral until the assets are withdrawn from a given account. If improperly accessed, these qualified assets are exposed to a 10% penalty and often 40% or more in federal and state income taxes. Depending on a person’s tax bracket and the state of residence, total penalties along with federal and state taxes can approach 50%.
So, the question to be answered is…
“How can a person access his or her retirement funds to purchase or capitalize a business while preserving tax deferral and avoiding penalties?”
Fortunately, federal law provides for exactly that, as the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) enables entrepreneurs to access accumulated retirement money to capitalize
their businesses. EGTRRA relaxed the portability rules for retirement plans, allowing assets created in several types of retirement plans to be rolled into each other.
For example, prior to passage of EGTRRA, a 401(k) Plan could only hold funds created in a 401(k) Plan. Under EGTRRA, funds created in other plans such as IRAs, defined benefit plans, traditional pensions, 403(b), etc…plans can be rolled into a single 401(k). This ability to transfer funds between plan types expanded the planning opportunity for entrepreneurs to use retirement funds as a business capitalization source.
When a business establishes a retirement plan such as a 401(k), the business becomes a “plan sponsor.” Once the plan is active, investment options are made available to the plan’s participants, who then select their investment options, preferably with the guidance of fiduciary-minded investment professionals. Retirement plans have had the ability to include the plan sponsor—that is, debt or equity issued by the company itself—as an investment option since the passage of the Employee Retirement Income Security Act of 1974 (ERISA).
However, ERISA imposes certain restrictions on a retirement plan’s ability to invest in a plan sponsor’s securities. In addition, the law limits the amount of funds that can be invested in a sponsor’s securities for plans that are allowed to invest in such securities. ERISA does not prohibit a plan’s acquisition or sale of qualifying employer securities of the sponsor and no limitation on the amount of funds that can be invested in a plan sponsor if the plan is an “eligible individual account plan.” An eligible individual account plan is defined as an individual account plan which is a profit-sharing, stock bonus, thrift, or savings plan. 401(k) plans fall under this definition.