Alright, everyone. Welcome back to the latest episode of the Great Retirement Debate. Ed, good to be back you once again?
Something that's come up recently. And, actually, over the years, a lot of money building up in IRAs For most people, it's their largest bucket of savings. And some people want to start a business, but it's the only pot of money they have to finance their new business. Should they use their IRA to fund their new business? Okay.
So should I use my IRA to fund my business?
Alright. No. Alright.
Well, tell us how you feel, Ed. That's interesting. So so obviously, you've you feel pretty, pretty strongly about this on that side. Why?
Why? Because it's dangerous. There are rules called prohibited transactions, possibly the worst penalty that can fall on your retirement savings. A prohibited transaction is, as it says, the tax law disallows certain transactions.
And not only did they disallow it, but it's so bad if it's done in an IRA, when I said you lose your IRA, it's disqualified. The IRA is treated as if everything came out of that IRA as of the first year of the prohibited first day of the year, of the prohibited transaction. So let's say, you have a million dollars in your IRA, and you commit a prohibited transaction.
And sometimes investing in a business and one of the key prohibited transaction involves self-dealing.
Could trigger a prohibited transaction. So you have a million dollars in your IRA, and you take ten thousand of it to fund your business, but you're in control of it, you're self-dealing.
The whole million is taxable.
And if you're under So not just the ten thousand years, but the whole point.
Matter of fact, that was made certain that that was, confirmed in the secure act. I was actually surprised that was in the original secure act. It just confirmed what we always thought, if you remember that. Yep.
So The whole million is taxable. And if you're under fifty nine and a half when you do it, a ten percent penalty on that million.
Alright. So you talked about prohibited transactions.
What prohibited transactions might I run across if I'm looking to fund my own business?
What are some of the things I can't do?
Self-dealing. That's basically the easiest term to understand borrowing money from your IRA lending money to your IRA.
Using IRA money for personal transactions, like investing in your own business that you can control. Now whenever I say this to somebody, because people you must get those questions. Also, I wanna invest in my own business. Sure. I have an IRA. I'm allowed to invest in IBM stock Why can't I invest in my company stock?
Congress said so.
Well, because you're you're generally people that are building or creating their own business are kinda hands on people. Sure. And the only way this really works, if you're a hands-off kind of person that you're investing in a business that you're not gonna work at, but you're investing. There?s is a big difference.
Yes. Yeah. They're very, very tough and, and and draconian rules if you end up committing one of these prohibited transactions, and it's kinda like threading a needle to use those dollars to to fund your own business without committing a prohibited transaction. But, you know, you talked about you said, you know, it's dangerous.
I said, why not? You said it's dangerous. Well, at danger is my middle name. So, you know, I'll I'll I'll I'll take maybe I don't wanna say if I I definitively take the other side on this one, but I I think that if if there are situations where you believe passionately that you have an idea and that this idea is going to allow you to create a lifestyle for yourself that you want, whether it's the income you want, or whether it's just the work life balance, working for yourself, or versus working for someone else.
And the only asset you have is your retirement account, then, you know, I I don't know if I'd say using your IRA as an IRA. But maybe just taking a distribution.
I was gonna say, yeah, that would be the way to go to have access to the money, pay the tax, maybe even the penalty.
As you said, if you really believe in it. Now the problem is, let me give you an example. Let's say you, are a contractor. This is a typical example. They have money in their IRA.
And they buy some dilapidated house and they wanna I'm gonna fix it up because I'm a contractor.
Right. Right. With that's self-dealing because you're working. If you could these are hands on people. That's their nature, but could you imagine somebody calling his direct competitor Well, I can't do it. Right. But can you hop can I hire?
I'd like to hire you to rebuild my house and manage it for rentals or something?
Like, if if it was hands off, that could work, but it generally doesn't happen that way. We saw a case years ago where and you wonder how of people how does IRS even find this? It came out of an audit.
A guy had some, land he owned in his IRA, which is fine. But he also had a contracting business.
And he parked one of his contracting vehicles.
On this land. And during the audit when they were claiming depreciation, and it turned out it was owned by the IRS Well, that's self dealing. That's a prohibited transaction, and the entire IRA was taxed.
Mhmm. So I I mean, I think we we agree on that. Now the problem, of course, is that even in those situations, you know, I I kind of advocated for, hey, if you have this business idea.
Right.
But the other challenge to that is You know, the anyone who does this thinks that their business is going to work out. Right?
You don't do this Right.
Going in saying, boy, this is not gonna work. But the reality is most small businesses fail within the first few years.
Right.
And if you've used if you're, you know, to your point, if you're saying the IRA is your only asset, because you have other money, that would be the money to use. But if your IRA is your only money, and you're using it to fund your business, and your business is like most small businesses, and it fails within a few years, now you end up with no job and no IRA, and you're even in worse situation than you were before. So, I mean, there there are I I I just, you know, even though I've sort of made the case for, okay, if you've got an idea, then, you know, you gotta take a chance sometimes in life. Well, There's the other side to that coin where you've gotta think about, well, what if I'm, like, most people, unfortunately, and this doesn't work out?
Right. Right. And Again, with the IRA, it's it's a problem. The problem is the people that do this, first of all, you can't go to a bank or broker, a mutual fund company.
Not a, a normal, a, traditional type asset, like stocks, bonds, and funds. You have to go to a self directed IRA custodian, and then they'll help you. They'll lay out the rules saying what you can do and what you can't, but they're not the police. If you misuse it, you could inadvertently because you didn't know the rules.
You thought you could just fix something up and, or you run your business through your IRA. And you missed one of these technical rules, everything Jeff said could happen because you've committed a prohibited transaction. Alright.
So there's is this. There's also another way out there that gets promoted a lot. And, by those who stand to benefit from the use of it. And it's a way to at at least as some would say, to use your IRA to start a business by not keeping it in the IRA, but by creating a business first, and then taking your IRA and rolling it into a plan of your new business, which is certainly allowed.
You can create a business. You can start a plan your business, and you can roll outside money into your new plan. But then what they do is they use that money inside the plan to fund the business. And and pay themselves.
Right?
Again, you're in a problem.
And this is so bad. I mean, it could work if you follow all the rules. But this is so bad that IRS has named this strategy a Rob's transaction.
Yes.
ROBS. It actually stands for rollovers business startups. Mhmm.
But if IRS is calling it a Rob's transaction, it's probably not a good indication.
They give I I remember years ago, they were talking about this on a on a call. And the person from the IRS, their response, you know, somebody said, well, are are can you can you actually do these things? And the person on the call said, theoretically. Right. I remember that. Theoretically that these things, but in practice, we don't like, it was one of those things.
Never even seen one that worked Yeah.
Something like that. Yeah. It was It's one of those things. Like, if you did everything right, well, the problem is when you when you actually go through and you do one of these Rob's transactions, there's there's several problems. One of them is might commit a prohibited transaction similar to the way we talked about with an IRA, but the other issue is the the way you fund your business with this is you have to buy shares of the business inside or buy units of the business inside your 401k with that 401k money. But when you do that, you have to value your business.
Right. And what is a new business worth Right.
For most new businesses, the answer is absolutely nothing. It has no value. So you can't, you know, you can't be buying shares at fair value and say, Oh, the the business just happens to be worth a million dollars. Why?
Oh, because that's the amount I had in my IRA at the time I rolled it in. No. That doesn't work like that. So Right.
That's not the value of the business, whatever I had in my IRA. Yeah.
That doesn't work like that.
Now where I see this sometimes working is if you can use that to maybe, like, on a where you franchise something and have a franchise here for us.
There can be a legitimate cost. And once you've paid that cost, there's some value there. And so you can actually but, you know, if you're just starting, you know, Ed's, you know, pizza shop, well, Ed's pizza shop on day one is not worth anything.
Right.
And so there's someone you don't know.
You haven't tasted the pizza, so Alright. I'm from New York, remember.
That's that's true. What what toppings are on it pizza by the way?
All of them.
All of them. Alright.
Well, pepperoni sausage, extra garlic.
Extra garlic. Alright. I'm glad we're separated.
That alone is prohibited transactions.
A transaction.
If you're around anybody.
Alright. So ultimately, we've got the situation where someone who who wants to invest in their business has this idea, but only has the retirement account is stuck in a situation where they either use it or maybe take it out or they don't get to to you know, to move forward with this idea. So, you know, with a final thought, like, what say you? If you were advising this individual, what do you tell them?
I would say I would almost always say don't do it because I'm afraid. You may break the rules. You may not be careful enough. A simple thing.
Like, let's say you invest in, a house, like I said before. It's easy example. But then you let your sister live there. Mhmm.
That's a prohibited transaction because it's self dealing. What if I left my sis  here's another question. What if I let my sister live there? But I she pays market rent.
Still no good.
No. Never good to have your sister living in your house. No. I said, kick her out, Ed.
You you you you so keep those family members away.
But I I might go to what you said before. If you really have a great idea, then take the money out of the IRA. The only money you're putting at risk is the tax money at that point.
Yep. And just be aware, again, like most people, you know, everyone thinks their idea is the one. Otherwise, they don't do this. But the reality and the statistics of the situation show that most of those people who believe fervently that they're right.
Is there any way to end this without the debit downer? Tone we have here?
Well, I guess we could say this. If you're fortunate enough to have built up enough money to invest in your business at some point, maybe you'll be able to be fortunate enough to to go back and build it. I don't know. There's no no.
There's no way. Nope. This is just yeah. This is just one of those things where it is is very difficult.
And if you're thinking about doing this, you know, maybe the upside here is that you need to think ahead and figure out where you're going to place your dollars. Maybe For some people, the IRA isn't the best place.
And here's another thing. I just thought about it because people their wheels might be turning. They say, wait a minute. Alright. So I won't use my IRA money, but I could borrow it. I could use it as collateral for a loan.
You good luck with that.
That's a prohibited transaction too.
Pretty much whatever you think about with your IRA, unless you're just going through the normal motions. There's a good chance it's a prohibited transaction. As you said, Ed, one of the more punitive penalties in the tax code, the immediate taxation of the entire account. And for a lot of people, if they're thinking about this, they probably are under the age of fifty nine and a half. Otherwise, you know, they they're probably the ones who are more likely to be starting a business at that point, which means a ten percent penalty on top of everything else.
Not so And by the way, on that loan example, just to clarify, with a personal guarantee.
That's right.
Yep. Alright. Well, and We had a good discussion today about an important topic as always. I appreciate it.
And let us know what you think. If you were in a position where you wanted to start your own business only money you had was in an IRA. Would you use it? Let us know.
You can reach out to Ed on Twitter @TheSlottReport or myself @CPAPlanner. Ed Good discussion as always. So we look forward to seeing you all on the next great retirement debate.