It is truly important to work at a company that you believe in. Having a job where you feel like you are contributing to the success of a growing business is wonderful. If you are able to invest in a business that you are passionate about, you may be able to see a financial return from your investment. You can make your investment very tax efficient by using a Roth IRA or pre-tax IRA.
Can you use your IRA to invest in a business you are already employed by? It’s important to understand the IRS prohibited transaction rules, which dictate what investments you can’t make with an IRA.
The IRA is not allowed to do certain types of transactions according to the Internal Revenue Code (“IRC”) Section 4975. There are two types of prohibited transactions: Direct Prohibited Transactions and Self-Dealing/Conflict of Interest Prohibited Transactions.
Direct Prohibited Transaction
The following text identifies transactions that are not allowed under IRS Section 4975(c)(1)(a), (b), (c). These transactions involve the IRA owner and any “disqualified person” in a sale, exchange, lease, service arrangement, or any direct financial transaction. Some examples of transactions that are not allowed are: (i) renting a home owned by your IRA to your parents, (ii) lending IRA money to your kids, or (iii) serving as the real estate agent for your IRA real estate investment.
A “disqualified person” is someone who is not allowed to transact with an IRA, according to Internal Revenue Code Section 4975(e)(2). This typically includes the IRA holder, their parents or children, and any entities in which the IRA holder has a controlling equity or management interest. You cannot make an investment with a parent, child, their spouses, or entities held by such. It is acceptable to transact with other family members, such as siblings, aunts, uncles and cousins, but not with members of the opposite sex.
Self-Dealing/Conflict of Interest Prohibited Transaction
A self-dealing/conflict of interest prohibited transaction is not as direct as a prohibited transaction that involves a direct financial relationship between the IRA and a “disqualified person.” This type of prohibited transaction generally has more flexibility in its application. Here’s an example: let’s say the IRA holder loans money to a company that they have a small ownership stake in and also manage. In this particular case, because the IRA owner owns less than 50% of the entity, the entity is not considered a “disqualified person.” However, if the IRA investment was done for any reason other than to exclusively benefit the IRA owner, then the self-dealing/conflict of interest prohibited transaction rules could be activated and make the transaction invalid.
Having spent time discussing the key rules concerning transactions that are not allowed under IRC 4975, let’s now look at the situation of an employee using their IRA to buy stock in a company they work for. Below is a list of questions, one should consider before making such an investment:
- Ownership in Business
- Size of Business
- Reason for Investment
Ownership in Business
It is not permissible to invest an IRA in a business that the owner, or any other “disqualified person” has a greater than 50% ownership stake in, according to IRC 4975. However, if the IRA owner has a minority interest in the business, the analysis is more complicated. If someone invested their Individual Retirement Account (IRA) in a business, would that be considered a prohibited transaction? Unfortunately, there is no exact answer. This answer is usually based on the facts and circumstances surrounding the event.
Size of Business
The size of the business the IRA owner works at is important. There is little chance that an IRA investment in a publicly traded company would cause a prohibited transaction. An IRA investment in a closely held business with less than five owners would probably require more scrutiny, as it could have a greater impact on the business and potentially directly or indirectly personally impact the IRA owner.
If you are looking to invest your IRA funds in a closely held business and you are an employee or executive of that business, it is important to make sure that your IRA ownership is less than 50%. An IRA that owns less than 50% can still be subject to IRS prohibited transactions if the IRS can argue that the IRA investment was done in a way that would directly or indirectly benefit the IRA owner or any “disqualified person.” In other words, it is crucial that the IRA owner show that the IRA investment was made to only benefit the IRA.
Reason for Making the IRA Investment
The IRA’s investment into the business is likely the most important determining factor of whether the transaction violates the IRS’ prohibited transaction rules. The IRS has rules that state that the IRA investment must only benefit the IRA and not the IRA owner or any person who is not allowed to have the investment. This means that an IRA owner can invest in a company as long as they do not own more than 50% of the company including the IRA ownership and the ownership of any “disqualified person”, as long as the reason for the investment was not for personal gain. The IRS could argue that the IRA made the investment to help the IRA holder or any “disqualified person” personally, which would be a prohibited transaction under IRC 4975.
Conclusion
In other words, if your IRA invests in a closely held business that you or a “disqualified person” are personally involved in, the IRS may take legal action against you. What you did and how you did it will affect how well you can defend yourself in an IRS investigation. It is important to keep less than 50% ownership in the company and to have evidence that the IRA’s investment was made to improve the IRA so that it will not be seen as a prohibited transaction.
BONUS: How to invest without a 401(k)
If your company does not offer a 401(k) plan, you have some alternatives. For example, anyone who has earned income can access an IRA and those who have their own business — even a side gig — have alternatives, too.
If your retirement plan at work is not up to par, there are eight other investing options you can look into.
1. Traditional IRA
An IRA, or Individual Retirement Account, is a common retirement savings plan that many people use in addition to other retirement plans. An individual retirement account (IRA) is a personal savings plan that offers tax advantages. Traditional IRAs allow you to save money on a tax-deferred basis. You will only have to pay taxes when you withdraw the money during retirement. You may be able to reduce the amount of taxes you owe by Contributing to this account.
2. Roth IRA
A Roth IRA is another way that workers can stash some cash for retirement, and it has two key differences from the traditional IRA:
With a Roth IRA, you can grow your money without having to pay taxes on it. You can also withdraw any of the money you’ve saved up tax-free once you retire. After-tax contributions are made in exchange for this benefit. This means that you will not receive any tax benefits from a Roth IRA now.
If you are expecting to have a lower income and tax rate in retirement than you do now, a Roth IRA may be a better choice for you than a traditional IRA. However, it is best to consult with a financial advisor to be sure.
3. SEP IRA
A ‘Simplified Employee Pension IRA’ (SEP) is an IRA account for people who are self-employed, own a business, or earn income from freelance or side jobs. The Self Employed Persons Individual Retirement Arrangement (SEP-IRA) functions similarly to a traditional IRA in that there are the same investment, distribution, and rollover rules. Instead of contributing $6,000 to a traditional IRA, participants can contribute up to $61,000 in 2022 or 25 percent of eligible compensation, whichever is less.
4. Solo 401(k)
If you have your own business and no employees other than a spouse, you can take advantage of a solo 401(k) which is a powerful savings vehicle. You are allowed to contribute a total of $61,000 for 2022, including $20,500 as an employee and $40,500 as an employer. If you are 50 years of age or older, you can contribute up to $27,000 to your employee retirement plan in 2022. This means that your total potential contribution could be as high as $67,500.
The best part about this type of plan is that you can save 100% of your income from your main job up to $20,500 per year (or $27,000 if you’re over 50 years old). You can contribute up to 25 percent of your business income to your pension plan. The maximum employer contribution is $40,500. An advantage that a SIMPLE IRA has over a SEP IRA is that your contribution to a SIMPLE IRA can be up to 100 percent of your business earnings, rather than being limited to 25 percent as it is with a SEP IRA. The amount of money you contribute to the plan can be either pre-tax or post-tax, depending on the organization that oversees the plan and the plan’s rules.
5. Health savings account
An HSA is a savings account that allows you to set aside pre-tax money to use for qualifying medical expenses. An HSA is a savings account that helps you pay for qualifying medical expenses with pre-tax money.
Accumulating a nest egg in a Health Savings Account (HSA) can provide a huge benefit for retirees and/or those who become covered by Medicare. Because your employer-provided health insurance plan is a high deductible health plan with a deductible of at least $1,400 for individual coverage or $2,800 for family coverage, and maximum out-of-pocket costs of $7,050 for individual coverage or $14,100 for family coverage, you are eligible for a tax-free health savings account. The plan for 2022 allows individuals to contribute up to $3,650 to an HSA and families up to $7,300. Employees who are 55 or older by the end of the tax year can contribute an extra $1,000.
In exchange for contributing to your HSA, you’ll get a amount of money subtracted from what you owe the government in taxes today, and the interest or other earnings on the account are free of federal taxes. If you live in a state that taxes contributions and earnings, you will still be able to withdraw the money tax-free as long as it is used for qualified medical expenses. The real benefit occurs when you turn 65 years old. You can avoid the 20 percent penalty for withdrawals or expenses for non-medical reasons if you do so when the withdrawal is considered taxable income. You can set up a HSA plan even if your employer does not offer one.
6. Taxable brokerage account
If you consider all the other options for retirement savings and none of them are feasible, you can always save money in an account at a brokerage firm. Assuming your workplace does not offer a 401k or similar retirement plan, you are responsible for picking an investment platform and broker that best suits your needs. If you are looking for brokers who charge low fees or you need to trade specific funds without paying a fee, you can do that.
7. Real estate
When it comes to real estate, investors are responsible for making good purchase decisions and increasing their profits. You can invest money for either immediate income (short-term cash flow) or for future gain (long-term appreciation).
8. Invest in a business startup
The excitement of funding a startup that could be the next big thing includes a high degree of risk. Crowdfunding platforms are a great way for startups to reach out to both potential investors and future customers.
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