Advisers may tell you that you can redirect your 401(k) into a small business. But watch out, because this is a very risky move.
By Jim Cramer and Wally Konrad, former senior editor for Smart Money magazine
NEW YORK (TheStreet) -- The ads are peppered throughout the Internet:
"Buy or start a small business using your retirement savings!"
"Finance a business or a franchise from your 401(k) -- without debt!"
Players like Guidant Financial and IRA Financial Group have armies of advisers waiting to tell you how to use a little known tax loophole to redirect your nest egg into what may be one of the riskiest investments ever: a small business.
The tax situation works like this. If you invest your 401(k) funds from a former employer to buy or start a business, you will be able to do so without the taxes and penalties associated with early 401(k) withdrawals. Instead you roll over the money into the business's retirement plan and use that money to invest in stock in the company. The rollover part means you avoid taxes and penalties. At the same time, buying the stock provides cash to start or buy the business.
The strategy only applies to C corporations (companies that are taxed separately from their owners), and you cannot use the 401(k) money to pay yourself or anyone else a salary. Keep in mind you can't roll over your 401(k) unless you have left your job. Funds from a 401(k) may be used to finance the entire purchase or start-up or can be used in conjunction with Small Business Administration loans and other financing.
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Like most tax dodges, this one is complicated. Most people who decide to use it pay a third party like Guidant or one of the other firms to help set up the new company's retirement plan and administer it each year.
Guidant CEO, Jeremy Ames, says the company has helped 7,000 people invest in a business since it started 10 years ago. Most bought existing small businesses, while only a few clients use the strategy for start-ups. After two years, 86% to 94% of Guidant clients were still in business; after four years, 60% survived, according to Ames.
Impressive as that may sound, the truth is this strategy is only appropriate for a tiny percentage of 401(k) savers -- those who are wealthy enough to know they have enough saved for a comfortable retirement and sophisticated enough to buy a business that will thrive.
In other words this probably isn't the way to start a Pinkberry franchise or the corner hardware store. "Small business is extremely risky, and most people shouldn't use retirement funds for risky investments," says Bill Harris, CEO of Personal Capital, an online financial adviser service.
Even Guidant's Ames agrees this isn't for every budding entrepreneur. He tells the story of one client who used her funds to open a dry cleaner, only to sell the business and take a loss a short time later. A loss in this case most likely means she lost a good chunk of her retirement savings.
Bad choices like these, however, are conveniently not Guidant's problem. Says Ames: "Our work is designed to weed out any compliance issues on the tax part. That's what we're good at. We are not small business finance experts. We don't advise on what transactions to invest in or not invest in."
Even sophisticated investors should think twice. I looked into doing this for a real estate business I was interested in, and my tax accountant said, "Are you out of your mind?" He said that the regulators would not like to see this if I am audited. That was enough for me.
Here's my bottom line. Unless you're one of those extremely well-off people we were talking about above (and if you are, you probably have the means and the credit rating to buy a business without dipping into retirement funds) you should not do this, no matter how tempting it may seem. Keep in mind, small businesses fail at extraordinary rates. Only one-third of new businesses stay alive for 10 years, according to the Bureau of Labor Statistics. Only one-quarter of them are still around in 15 years. With odds like that, do you really want to risk your retirement money?