I need some advice. I am contemplating using my 401k to invest in a business with several of my current coworkers. The company I currently work for is closing us down and prospects of gaining employment elsewhere in this industry is highly unlikely. We have turned a small profit in recent months even with the substantial corporate overhead burden so we are confident we can turn a profit with a lesser overhead percentage. I do not want to miss this opportunity to invest in this new venture but I only have my $160,000 401k available to invest. I understand the tax and 10% penalty for early withdrawal. Is there any way to minimize the cost of cashing out by maybe rolling it over to an IRA or Roth IRA and then cash out or would the tax and penalty be the same? Also, is the tax rate based on my most recent tax return, i.e. 2008?
You won’t be able to use retirement to start your business. It might work if you weren’t a principal or had significant control or ownership over the company. Perhaps you can purchase the business from the current owners and pay them through the small profit you are able to generate.
You can only rollover a 401k into a traditional IRA without tax penalty. Direct 401k to Roth rollover is not permitted.
Liquidating your 401k and liquidating a traditional IRA incur the same tax liability – ordinary income taxes on the liquidation amount plus 10% early withdrawal penalty.
If you convert a traditional IRA to a Roth IRA, you pay ordinary income taxes on the conversion amount. If you withdraw of any portion of your conversion amount within the first five years after conversion, the 10% early withdrawal penalty applies. If the withdrawal of conversion funds occurs later than five years after conversion, there is no early withdrawal penalty.
Ordinary income taxes are assessed at the marginal tax rate in which the income is earned. If you are in the 15% tax bracket, and if the first dollar withdrawn from your 401k pushes you into the 25% tax bracket, then all of your 401k withdrawal will be taxed at the 25% rate. Your bracket rate this year is determined by your income this year.
If I simply cash out the 401k, pay the taxes and 10% penalty, I can use that cash for whatever I like, correct?
That is basically what nearly everything you would read would tell you not to do. The stock market has been terrible, but that is precisely the wrong time to get out.
f you have a sound plan to put the money to work, then either/or of these options will be fine. 2 years ago I would have said don’t touch your 401K but now… I would keep my options open.
Yes, you can cashout your 401k and do anything you want with the money. Understand that when you cashout your 401k, you will have ordinary income taxes and a 10% penalty on the amount withdrawn.
If you are in the 25% tax bracket, cashing out a $100K 401k will leave you just $60K after federal taxes are paid, less if your state also has a state income tax.
Why lose 40% of your buying power by cashing out your 401k, when you can reinvest the entire $100K if you do a rollover into a self-directed IRA?
Dave,
You’re right. One drawback is I have to wait another 30 years before I can access that money. Who knows what can happen in that time?
The IRS has very strict rules regarding what can and cannot be purchases with IRA funds. There are also limits on what you can personally do with the investments (i. e. can’t work on rehabs). Self-directed IRAs are good for truly passive investments like tax liens and private placements.
I have done a lot of research about this lately because I have a client who wants me to help him open a self-directed IRA.
You need to roll your 401(k) into a traditional IRA, not a Roth IRA, to avoid taxes.
You can set up the self-directed IRA with any number of custodians. Some offer the “checkbook” option, in which you fund the IRA and form an LLC, then the IRA buys membership interest in the LLC, then the LLC invests in real estate. However, this is kind of a gray area and the company I use (Sterling Trust in Waco) will not do this. You cannot “self-deal” with the IRA and this kind of looks like self-dealing to me.
Sterling Trust requires that there be a non-disqualified person unrelated to the IRA holder who owns at least 50% of the LLC, or they will let the IRA invest in real estate directly if the holder provides a management agreement with a third party (such as an attorney :). The custodian would accept a distribution letter from the IRA holder and distribute the requested funds to the manager, who could then fund the real estate investment as directed by the IRA holder.
I haven’t seen anything that says the “checkbook” self-directed IRAs are out of bounds, but they seem to violate the concept of what the IRA is. You are not supposed to directly manage the IRA’s investments.
This may be why someone keeps posting that you can’t use IRAs for rehabs, but I’ve never seen any IRS document that says anything to that effect. IRAs can be used for any type of real estate investment; it’s the management and participation that is at issue. There are some CUSTODIANS that will not allow real estate investments, or certain types of real estate investments, but that’s the custodian, not the IRS.
For more: http://www.irs.gov/retirement/article/0,,id=111413,00.html
Supposedly, the benefits are no state filing fees or franchise taxes. It is quicker to setup. And lower total cost of ownership versus the LLC.
but I've never seen any IRS document that says anything to that effect.
no prohibitions on the IRA doing rehabs, but there are rules regarding the IRA owner doing the rehab work himself.
There is a reason why the custodians don’t touch it.