The retirement account regulations allow business owners or aspiring entrepreneurs to invest their own retirement funds in their own business (known as an active investment) or a third-party business (commonly referred to as a passive investment). Both of these investment types will not subject the retirement account holder to taxes or penalties as long as the investment rules are followed.
Investing Retirement Funds in Your Own Business (known as an active investment)
The technical term to define the process of investing one’s own retirement funds in his or her own business is known as a rollover as business startup (ROBS 401k/PSP).
The following specific rules apply when investing your own retirement funds in your own business.
- First, in the case of a new business, a new C-Corporation is established that then adopts a 401k/PSP plan.
- The qualified retirement plan must include language that allows for investing in employer stock.
- Once the new 401k/PSP has been adopted, it may be funded with IRA funds (Roth IRA and Roth 401k funds do not qualify) and/or former employer funds such as 401k, 401a, 403b, 457, Defined Benefit Plans and Pension plans.
- Funds from IRAs or former employer plans are then rollover over to the new ROBS 401k/PSP.
- After the former employer or IRA funds have been transferred, the business owner/trustee self-directs his new 401k to invest in the C-corporation’s newly issued stock shares.
- Lastly, the business owner uses the C-Corporation proceeds from the sale of the stock to the 401k to purchase an existing or start his or her new business venture.
Investing Retirement Funds in a Third-Party Business (i.e., a business not owned by the retirement plan participant-referred to as a passive investment)
When the business owner invests his 401k retirement funds in a business that is owned by someone else, it is deemed a passive investment so the business owner cannot be active (an employee) in the third party’s business.
In order to invest 401k retirement funds in a third-party business, the investor must be self-employed so that he or she can open a self-directed solo 401k plan.
- After the solo 401k has been opened, the self-employed business owner can transfer his or her former employer retirement funds and/or IRA funds to the new solo 401k.
- The self-employed business owner then self-directs his solo 401k funds to purchase an equity interest in the third party business by writing a check or wiring the funds from the solo 401k bank account to the third-party business bank account.
- All investment gains that result from the third-party investment must flow back to the solo 401k bank account.
In sum, the 401k rules vary greatly depending on whether one invests his or her retirement funds in his or her own business versus investing 401k funds in a third party’s business.