Draw from 401K to Invest in Business

[The Occultist]

What is the name of your state (only U.S. law)? AZ

I wasn't sure which forum was the best to post this, so I randomly chose this one.

I know that I can withdraw from my retirement fund to invest in my own business and avoid the penalty, but am I able to withdraw to invest into somebody else's business and still avoid that penalty?

 

[LdiJ]

What is the name of your state (only U.S. law)? AZ

I wasn't sure which forum was the best to post this, so I randomly chose this one.

I know that I can withdraw from my retirement fund to invest in my own business and avoid the penalty, but am I able to withdraw to invest into somebody else's business and still avoid that penalty?

I am sorry, but there is no exclusion from penalty for investing in your own business. Therefore, of course there is no exclusion from penalty for investing in anyone else's business.

If you have a self directed IRA, that can be used to invest in anything that you think its appropriate to invest in. However, it must be an official self directed IRA.

 

[Taxing Matters]

What is the name of your state (only U.S. law)? AZ

I wasn't sure which forum was the best to post this, so I randomly chose this one.

I know that I can withdraw from my retirement fund to invest in my own business and avoid the penalty, but am I able to withdraw to invest into somebody else's business and still avoid that penalty?

Actually, no, you cannot avoid the 10% early withdrawal tax (what most people refer to as a penalty) by using the funds to invest in any business, whether it is a business you own or a business owned by someone else. The exceptions for early distributions from retirement plans and from IRAs are a bit different, but in neither case is a distribution excepted from the penalty due to using the funds to invest in business.

 

[Taxing Matters]

If you have a self directed IRA, that can be used to invest in anything that you think its appropriate to invest in. However, it must be an official self directed IRA.

Just so it is clear to the OP, a self-directed IRA would not solve the problem of an early distribution from his retirement plan. He might be able to rollover an existing IRA into the self-directed IRA to invest in the business without incurring the penalty, but a roll over is a different thing than a distribution.

 

[cbg]

The law does not place any restrictions on the reasons a loan can be taken from a 401(k). Not all plans allow for loans, and it is possible that a specific plan could place limits on the reasons. But while I agree 100% that there is no provision to take a hardship withdrawal from a 401(k) to invest in a business, it's conceivable that a loan could be taken for that reason.

A loan would have to be paid back, with interest, and if the employment ended there would be a penalty applied if it were not paid back more or less immediately, and taxes on it at the end of the year. But it is within the realm of possibility. It's not considered the same as an early distribution.

 

[LdiJ]

Actually, no, you cannot avoid the 10% early withdrawal tax (what most people refer to as a penalty) by using the funds to invest in any business, whether it is a business you own or a business owned by someone else. The exceptions for early distributions from retirement plans and from IRAs are a bit different, but in neither case is a distribution excepted from the penalty due to using the funds to invest in business.

Thanks about mentioning the rollover into a self directed IRA. I probably was not clear enough that its the IRA that has to invest in the business. I did however say that it had to be an official, self directed IRA.

 

[Taxing Matters]

I did however say that it had to be an official, self directed IRA.

Yes, you did.

But neither of us mentioned something else that is not strictly speaking a tax issue but is important to mention nevertheless: while you CAN do a lot of different investments with a self-directed IRA, a lot of them SHOULD NOT be done because they are too risky to bet your retirement on. Many small businesses fail; a person takes a great risk in using retirement funds to invest in a new business and one should think really hard about that before taking that plunge.

 

[LdiJ]

Yes, you did.

But neither of us mentioned something else that is not strictly speaking a tax issue but is important to mention nevertheless: while you CAN do a lot of different investments with a self-directed IRA, a lot of them SHOULD NOT be done because they are too risky to bet your retirement on. Many small businesses fail; a person takes a great risk in using retirement funds to invest in a new business and one should think really hard about that before taking that plunge.

Believe me, I understand about the SHOULD NOT. I have a client who lost nearly a million in retirement assets due to how he decided to invest his self directed IRA. He became my client after that happened or I would have seriously discouraged him.

 

[Taxing Matters]

Believe me, I understand about the SHOULD NOT. I have a client who lost nearly a million in retirement assets due to how he decided to invest his self directed IRA. He became my client after that happened or I would have seriously discouraged him.

I too have seen clients and others that have similarly screwed up in their self-directed IRAs. They get all pumped up about using self-directed IRAs based on sales pitches of promoters and get to thinking this is the greatest thing since sliced bread and do not give much thought to the fact that they playing with their retirement funds. Then when they lose it all because the business or speculative investment went south they are devastated, in some cases left with pretty much nothing for retirement. That’s a bitter pill to have to swallow, especially if the person is over 50 and doesn’t have a lot of time to rebuild his/her retirement savings. It always makes me sad to see these situations.

 

[quincy]

It is good to see you back on FA, The Occultist, even if it is only to ask a question rather than answer one.

 

[The Occultist]

It is good to see you back on FA, The Occultist, even if it is only to ask a question rather than answer one.

haha Thanks Quincy!

Hey all, thank you for the information; definitely good to know.

I'll ask another question while I'm at it:

A new LLC was created a few days ago in 2017, but has not yet registered for an EIN. Will taxes need to be filed for 2017 (reporting no income, but a loss due to expense on the filing fee)? or leave it alone until 2019 when filing for 2018?

And don't worry, I'll have a local CPA signed up soon! ;-)

 

[LdiJ]

haha Thanks Quincy!

Hey all, thank you for the information; definitely good to know.

I'll ask another question while I'm at it:

A new LLC was created a few days ago in 2017, but has not yet registered for an EIN. Will taxes need to be filed for 2017 (reporting no income, but a loss due to expense on the filing fee)? or leave it alone until 2019 when filing for 2018?

And don't worry, I'll have a local CPA signed up soon! ;-)

You cannot file a tax return for an entity formed in 2017 that did not also get an EIN number in 2017. The IRS won't recognize it for 2017.

 

[The Occultist]

Perfect, that's exactly what I was hoping to hear!

 

[Taxing Matters]

You cannot file a tax return for an entity formed in 2017 that did not also get an EIN number in 2017. The IRS won't recognize it for 2017.

I disagree. The failure to get an EIN on time does relieve a taxpayer of its filing obligations, after all. For example, if Joe and Brenda form a LLC on 1/1/2017 and the LLC makes $10 million that year but they do not file for an EIN for the LLC until shortly before filing the Form 1041 for it in 2018, getting the EIN in 2018 will not relieve the LLC of its return filing obligation. Whatever problems the IRS might have in processing that return (which would be of its own making rather than anything imposed by law) it would still need to accept and process that return. The taxpayer is required to file it by law, and the taxpayer (and its owners) cannot escape the taxes due simply by the fact that the EIN was obtained late.

Moreover, where the LLC is a single member LLC that has not elected to be taxed as a corporation, the separate existence of the LLC is ignored for federal income tax purposes and the income, deductions, and credits of the LLC are treated as the income, deductions, and credits of the owner. Thus, the income tax reporting requirement is for the owner, not the LLC, and the fact that the LLC does not have an EIN would not prevent the owner from reporting the income, deductions, and credits of the LLC on the owner’s return.

The issue I see is that there is nothing to report for this LLC in 2017 anyway. The only expense incurred was the filing fee to set up the LLC. That expense is not deductible since expenses incurred prior to a business starting operation cannot be deducted. These start-up expenses are instead amortized starting from when the business begins operation under IRC § 195. While a portion of start up expenses may be deducted rather than amortized at the election of the taxpayer, that deduction is taken in the year the business begins operations. Thus, this expense would not be taken until the year actual business operations were to begin.

So I agree that there is nothing to file for 2017, but not because the EIN was not obtained until 2018. Rather, because there is simply nothing to report for 2017.

 

[LdiJ]

I disagree. The failure to get an EIN on time does relieve a taxpayer of its filing obligations, after all. For example, if Joe and Brenda form a LLC on 1/1/2017 and the LLC makes $10 million that year but they do not file for an EIN for the LLC until shortly before filing the Form 1041 for it in 2018, getting the EIN in 2018 will not relieve the LLC of its return filing obligation. Whatever problems the IRS might have in processing that return (which would be of its own making rather than anything imposed by law) it would still need to accept and process that return. The taxpayer is required to file it by law, and the taxpayer (and its owners) cannot escape the taxes due simply by the fact that the EIN was obtained late.

Moreover, where the LLC is a single member LLC that has not elected to be taxed as a corporation, the separate existence of the LLC is ignored for federal income tax purposes and the income, deductions, and credits of the LLC are treated as the income, deductions, and credits of the owner. Thus, the income tax reporting requirement is for the owner, not the LLC, and the fact that the LLC does not have an EIN would not prevent the owner from reporting the income, deductions, and credits of the LLC on the owner’s return.

The issue I see is that there is nothing to report for this LLC in 2017 anyway. The only expense incurred was the filing fee to set up the LLC. That expense is not deductible since expenses incurred prior to a business starting operation cannot be deducted. These start-up expenses are instead amortized starting from when the business begins operation under IRC § 195. While a portion of start up expenses may be deducted rather than amortized at the election of the taxpayer, that deduction is taken in the year the business begins operations. Thus, this expense would not be taken until the year actual business operations were to begin.

So I agree that there is nothing to file for 2017, but not because the EIN was not obtained until 2018. Rather, because there is simply nothing to report for 2017.

We have had no less than half a dozen returns get completely rejected by the IRS (even by paper) because the EIN number had not been obtained until the following calendar year. All of them happened in the last 10-15 years. Granted, none of them had any actual income yet (not for lack of trying), only expenses, but they were completely rejected, first electronically and then paper.