Should you Purchase a Business with a Self-Directed IRA?
Should you purchase a business with your self-directed IRA? In my humble opinion, NO. And my opinion is based on experience and knowledge. You see, I started my first business with a self-directed IRA.
Using a self-directed IRA to start a business seems appealing. You get to access your IRA savings tax-free with no early withdrawal penalty. It’s a no-brainer, right? Wrong. You end up paying way more in taxes. It’s a bit complicated, but I will walk you through this.
When you start or buy a business funded by a self-directed IRA, you have to set up a C-corp. The C-corp will not allow you to withdraw your capital contributions for tax-free and you end up paying double payroll taxes on the W-2 income you make in relation to the amount of money you invest from your self-directed IRA.
To best illustrate why you pay much taxes with a self-directed IRA funded business, let’s make a few key assumptions:
You need $200K to purchase a $2M business. $1.8M of the purchase price is funded with an SBA loan and seller financing.
You have $400K in your IRA
The effective income tax rate is 26%; The IRA early withdrawal penalty is 10%; C-Corp effective tax rate is 20%; and the self-employed payroll tax is 15.4% for Social Security and Medicare.
Based on the assumptions above, let’s compare two options with a series of steps. For the first option, you withdraw funds from your IRA and pay both the penalty and income taxes on it. For the second option, you set up a self-directed IRA to fund the business.
Step One
Option 1 - You withdraw $312.5K to net $200K for your down payment. You pay $112.5K in income taxes and an early withdrawal penalty. You set your company up as an S-Corp or an LLC.
Option 2 - You withdraw $200K from the self-directed IRA and pay someone like Guidant around $7,500 to set it up and another $1,500/year or so to maintain the company’s 401K (Yes, you have to set that up with a self-directed IRA funded business).
In Step One, you save about $105K in taxes with Option 2. This is about as far as most people see when thinking about using a self-directed IRA, but this is a big mistake.
Step Two
As you run the business, you need to pay yourself. With Option 1, you can take $200K out of the business tax-free. You already paid taxes on the $200K so you can withdraw what you invested without taxes.
For Option 2, you need to pay yourself $340.7K to net $200K. $140.7K is used to pay both income and payroll taxes.
You pay $140.7K more in taxes + the $1,500 annual maintenance fees for the C-corp’s 401K with the second option.
Combining Steps 1 and 2, you can see you have paid about $36K more in taxes using a self-directed IRA. If the analysis ended there, it’s basically a wash, but this is not the end of the story.
Step Three
Your business is humming along and so you decide it’s time to pay back your self-directed IRA the original $200K. You may have to pay back more than this because your company has probably gained value, but let’s stick with $200K. (Note: You will be required to do a 3rd party business valuation to determine the value of the stock owned by your IRA.)
With Option 1 you can put $200K in IRA tax-free over a period of time. With Option 2, you buy back the stock from your self-directed IRA with after-tax earnings. So you will need to make about $250K in company earnings to net $200K.
So you pay $50K more in taxes with Option 2 in step three. Adding steps one through three, you have now paid about $86K more in taxes for Option 2
The Take-a-way
Using a self-directed IRA to start or acquire a business will almost always cause an owner to pay much higher taxes. And if that’s not enough, there is a lot more ongoing paperwork and compliance associated with a C-Corp and self-directed IRAs. I hope this blog post helps you make the best decision for your personal circumstances.
If you want to evaluate different scenarios, please see the link below. You can also request a Microsoft Excel Template by contacting us.