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How to Use Your IRA to Invest in Startups

What is an IRA?

According to Fidelity Investments, the definition of an IRA is, “an account set up at a financial institution that allows an individual to save for retirement with tax-free growth or on a tax-deferred basis.” There are four, most familiar, IRAs — Traditional, Roth, SEP, and Rollover — each with different advantages.

All IRA’s have the ability to invest in all asset classes, but it is the custodian where the account is held, which can limit your investment choices. Making your IRA a “Self-Directed IRA” gives you more flexibility with regard to where your assets are invested.

Investing via Self-Direct IRA's

What is a Self-Directed IRA?

This classification of your IRA, as the name implies, differs from the typical IRA in that the individual decides or “directs” the investment choices in their account. These types of IRA’s allow for individuals to invest in assets beyond traditional IRA’s which invest in stocks, bonds, and mutual funds. Self-Directed IRA’s allow for alternative investments, including but not limited to real estate, startups, coins, precious metals, etc.

In order to participate in a self-directed IRA you need a custodian who can house alternative investment assets and provide the appropriate record keeping services for these assets. Generally, these custodians are considered “passive” in that they do not give you investment advice but rather provide oversight services.

Forbes provides some further insights on the types of investment assets available through a self-directed IRA as well as further clarifications and insights which you might find useful.

Why Invest in Startups with your IRA?

If you don’t plan on withdrawing from your IRA for few years, startup equity could be a good investment to fit your long-term goals. With the average exit for a startup 7 years from inception, this type of investment is already a long-term commitment. The startup benefits from your long-term commitment while you can aid in directing the growth of your investment.

Investing in a startup through your IRA limits your control over the company but it doesn’t limit you from being on the board or acting as an advisor. As long as you’re not the head employee or in possession of over 50% of the company, you can be as involved in a startup as it will allow. A self-directed IRA can legally own a variety of things, such as real estate, promissory notes, gold, and gas.

Limitations of Investing with a Self-Directed IRA

The main restrictions of a self-directed IRA are known as self-dealing rules. According to these rules, your investment may not allow you to be the key investor in a business, so you’ll be fine as long as your investment doesn’t constitute more than 50% of the startup’s equity. You’re also not allowed to be the key employee, or in a position from which you cannot be fired.

There are also restrictions as to whose business you can support with your self-directed IRA. You cannot invest in a business if it belongs to your spouse, parents, or children. However, you are allowed to invest in a business that belongs to a friend, sibling, or business associate.

Risks of a Self-Directed IRA

The main risks result from neglecting to follow self-dealing rules outlined above. Failing to follow these rules could cause your entire IRA to be immediately taxed, defeating the purpose of trying to shelter yourself from taxes in the first place.

You must also begin to take an annual required minimum distribution (RMD) starting at age 70 ½, unless it is a Roth. Determining the amount of your RMDs ahead of time will help you determine how much you can invest, and for how long. Failing to take these distributions could result in a penalty equal to 50% of the required payout.

If a seemingly lucrative investment opportunity is not so lucrative after all, the custodian issuing your IRA is not liable for your bad investment. Whether it’s a flop or a scam, you are solely responsible if your investment really is too good to be true. As with all investments, you should always do your research and err on the side of caution.

When to Use a Self-Directed IRA

Self-directed IRAs are a great blend of tax shelter and growth potential for your retirement funds. Investing in startup equity enables you to create a lasting partnership with a business. If you’re willing to follow the rules and make long-term commitment, a self-directed IRA may be an investment tool for you to consider.