Can a Self-Directed 401(k) Be Used to Invest in a Startup or Private Company?

Are You Allowed to Invest in Startups or Private Companies Through a Solo 401K?

Yes, you can use money in a Solo 401(k) to invest in certain private companies instead of limiting your retirement savings to stocks, bonds, and mutual funds. The main difference is that your 401(k) makes the investment, not you personally. So if the investment is allowed, the private company’s ownership interest would belong to the retirement plan.

There are still some limits. The company must be willing to accept your Solo 401(k) as an investor, your plan must allow this type of investment, and the transaction cannot give you a personal benefit that the IRS prohibits. The type of company also matters. For example, a Solo 401(k) generally cannot own shares of an S corporation.

3 Rules for Investing in Startups With a Solo 401K

You can invest in a startup through a Solo 401(k), but you cannot treat your retirement account like a regular bank account.

Before making an investment, keep these three rules in mind.

1. You Must Be an Accredited Investor

You may have heard that you need to be an accredited investor to invest in a startup.

That is not always true. Whether you need to be accredited depends on how the startup is offering its investment. Some private offerings are available only to accredited investors. Others can accept certain investors who do not meet the accredited investor requirements.

For example, a startup raising money under Rule 506(c) generally has to sell its securities only to accredited investors. A Rule 506(b) offering can include a limited number of non-accredited investors who meet certain requirements.

So, if you find a startup you want to invest in, ask:

“Does this offering require investors to be accredited?”

If the answer is yes, you then need to determine whether you or your Solo 401(k) meets the applicable requirements. The important thing is not to assume that having a Solo 401(k) automatically makes you an accredited investor.

2. You Cannot Invest in an S Corporation

If a startup is set up as an S corporation, your Solo 401(k) cannot buy its shares. This is because S corporations have specific rules about who can own their stock, and retirement plans are not among the permitted shareholders.

So before investing in a private company, simply ask:

“Is this company an S corporation?”

If the answer is yes, you cannot use your Solo 401(k) to purchase its stock.

If it is another type of business, such as a C corporation or certain LLCs, the investment may be possible. You would still need to check the other Solo 401(k) rules and make sure the company allows retirement plans to invest.

3. You Cannot Use the Investment for Your Own Benefit

This is probably the most important rule to understand.

The IRS has rules called prohibited transaction rules. In simple terms, these rules stop you from using your retirement account to benefit yourself personally. Your Solo 401(k) is supposed to hold money for your retirement. You cannot move that money into a business arrangement and then use the investment, property, or money for your own personal benefit.

For example, you cannot have your 401(k) buy an investment and then personally use the company’s property as if you owned it.

The rules also restrict certain transactions between the retirement plan and people connected to it. These people are generally referred to as disqualified persons. This can include you, certain family members, and other people who have a specific relationship with the retirement plan.

Tax and Reporting

Taxes are another reason investors consider using a retirement account for startup investments.

If you use Roth Solo 401(k) money, qualified withdrawals can generally be taken tax-free. So if a startup investment grows significantly over time, the gains may eventually be withdrawn without federal income tax if all the Roth distribution requirements are met.

Traditional Solo 401(k) money works differently. You generally receive tax-deferred treatment while the money remains in the account, and taxable distributions are generally taxed when you withdraw them.

There can also be additional tax rules when a private investment involves debt.

This is particularly worth paying attention to if the startup investment involves borrowing or leverage. The tax treatment can be different for a 401(k) and an IRA, so do not assume the two accounts will produce the same result.

If debt is involved, have the investment reviewed before moving forward.

The Advantage of Investing in Startups With a Solo 401K

So why would someone even consider putting a startup investment inside a Solo 401(k)?

There are a few possible reasons.

1. Tax-Free Roth Gains

This is one of the more interesting possibilities.

Let’s say you put $20,000 of Roth Solo 401(k) money into a startup. Years later, the investment becomes worth $100,000.

If you meet the requirements for a qualified Roth distribution, you could potentially withdraw that $100,000 without federal income tax.

That means the $80,000 increase in value could potentially be received tax-free.

Of course, this only matters if the investment actually succeeds. Startups are risky, and you can lose money too.

2. Higher Contribution Limits

A Solo 401(k) generally gives eligible business owners much more contribution room than an IRA.

You can contribute as an employee and may also be able to make employer contributions through your business.

The exact amount depends on your income and the IRS limits for the year.

For someone who wants to build a larger retirement account, that extra contribution room can make a difference.

3. More Investment Choices

A regular 401(k) usually gives you a list of investments chosen by the plan provider.

A Self-Directed 401(k) can give you more freedom.

Depending on the plan, you may be able to invest in things such as:

• Certain private companies
• Real estate
• Private equity
• Promissory notes
• Other alternative investments

This does not mean every investment is allowed. You still have to follow the plan’s rules and the IRS requirements.

4. Potential Advantage When Debt Is Used

There can be another benefit when an investment involves debt.

IRAs can be subject to tax on certain income connected to debt-financed investments. Qualified retirement plans such as 401(k)s generally receive different treatment under these rules.

This can make a 401(k) attractive for certain leveraged investments.

However, this area can get complicated quickly. The tax result depends on the investment and how it is structured, so it should be reviewed before you invest.

Can I Invest in My Own Startup With a Solo 401K?

Generally, you cannot simply use your Solo 401(k) to invest in your own startup.

The issue is that you have a personal relationship with the company.

If you own or control the startup, putting your retirement money into that business could allow you to benefit personally from your retirement account. That can create a prohibited transaction.

For example, you cannot simply say:

“I have $60,000 in my Solo 401(k), so I’ll move $30,000 into my own startup.”

That is not how a Solo 401(k) is supposed to work.

The rules are there to keep your retirement money separate from your personal business dealings.

There are more complicated structures involving business owners and retirement plans, but they have very specific requirements. If you are trying to use retirement savings to fund your own company, get professional advice before moving any money.

Alternative: Solo 401K Loan

If your goal is simply to get money from your Solo 401(k) to help fund your business, a Solo 401(k) loan may be an option if your plan allows participant loans.

This works differently from investing in your company.

Your 401(k) does not become an owner of the business. Instead, you borrow money from your retirement account and repay it back to the account.

Under the general IRS rules, a qualifying plan loan can generally be:

• Up to 50% of your vested account balance
• Limited to $50,000
• Repaid over a maximum of 5 years in most cases
• Repaid at least quarterly

Your plan must allow loans, and the loan has to follow the required rules.

The interest rate also needs to be reasonable. There is no universal IRS rule that says every Solo 401(k) loan must be set at prime plus a specific percentage.

Hypothetical Example

Let’s say your Solo 401(k) has $80,000 in vested funds.

Under the general 50% rule, you could potentially borrow $40,000 if your plan allows loans and you meet the other requirements.

You could then use that $40,000 to help fund your startup.

But there is a catch.

The $40,000 is no longer invested inside your retirement account while you are using it. That means it may miss out on investment growth during that period.

You also have to make your loan payments on time. If you fail to follow the loan terms, the unpaid amount could be treated as a taxable distribution. An additional tax may also apply depending on your age and circumstances.

So a Solo 401(k) loan can give you access to capital, but you are still taking money away from your retirement investments.

Due Diligence Before Investing

Finding a startup that looks promising is only the beginning.

Before putting retirement money into a private company, go through these checks.

1. Verify the Company Is Legitimate

Find out who owns the company, who runs it, where it is registered, and what it actually does.

Do not rely only on a pitch deck or sales presentation.

2. Read the Offering Documents

Before investing, understand exactly what you are buying.

Look at:

• The type of investment
• The company’s valuation
• Your ownership percentage, if applicable
• Investor rights
• Fees
• How the company plans to use your money
• Restrictions on selling the investment

3. Make Sure You Can Leave the Money Invested

Private company investments can be difficult to sell.

There may not be a stock exchange where you can sell your shares whenever you want.

You may have to wait years for the company to be acquired, go public, or provide another opportunity for investors to exit.

That is especially important when you are using retirement money.

4. Check for Prohibited Transactions

Look at your relationship with the startup.

If you, your spouse, certain family members, or another related person owns or controls the company, do not assume the investment is allowed.

Have the transaction reviewed first.

5. Confirm Your Plan Allows the Investment

A Self-Directed 401(k) can offer more investment choices, but your particular plan still has its own rules.

Make sure the plan actually allows the type of private investment you want to make.

6. Speak With a Professional

Private investments can involve retirement rules, tax rules, and securities regulations at the same time.

If you are unsure about any part of the transaction, speak with a qualified retirement or tax professional before investing.

It is much easier to check a transaction beforehand than to deal with a prohibited transaction later.

Want to Learn More About Self-Directed Retirement Investing?

If you are new to self-directed retirement accounts, it helps to understand how they work before looking at private investments.

Watch the video below for a simple introduction to self-directed retirement investing and the additional choices these accounts can provide.

Closing Thoughts

A Self-Directed 401(k) can potentially be used to invest in a startup or private company, but there are some important boxes to check first. The investment must be permitted by the plan, the company must be able to accept the retirement plan as an investor, and the transaction must stay within IRS rules. You also need to be careful if you have a personal connection to the company. If your goal is to invest in an unrelated startup, a properly structured Self-Directed 401(k) may give you that option. If your goal is to fund your own startup, a Solo 401(k) loan may be worth exploring instead.

Frequently Asked Questions About Investing in Startups with a Self-Directed 401(k)