Craig, a reader here on the Patch, asked the following question: “I have heard of people using their old 401(k) plan as startup capital for a new business… If you are familiar with this strategy, I think an article about it would be wonderful.“

Thanks for the question Craig. I usually don’t get all legal with my posts, but this is a very technical question so for the purposes of pleasing my compliance officer, I will give a disclosure statement.

I do not recommend the following strategy to you or anyone else without meeting and reviewing your situation. If you choose to utilize this strategy, you will need to consult with a financial advisor, accountant, and lawyer that have done a number of these transactions before getting started.

Most Americans have the majority of their savings in retirement accounts. With unemployment high among older workers, some are beginning to ask if they can use money in their 401(k) and/or IRA to fund a business start-up. The short answer is yes… the long answer is much more complicated and it is almost impossible to actually do legally.

Step 1: Think this through

Are you sure you want to risk your retirement nest egg on a business startup? Last I saw, only 1 in 5 small businesses make it past 5 years. The IRS found that most new businesses using this funding strategy failed. You are taking a huge risk by starting a business. Using your retirement funds to help pay for the startup is even more risky. If you have any other funding options, such as a loan from a bank, personal savings, or other investors, please consider those options.

If you decide this is what you want to do, move to step 2.

Step 2: Form the company

You will have to form a C-Corp with the State in which you are opening the business. This strategy is now allowed for any other business entity, so no partnerships, s-corps, LLC’s or sole proprietorships. You will then issue shares of the C-Corp for purchase.

Step 3a: 401(k) funds – Establish company retirement account

If you want to use money from your 401(k), you will need to set up a new 401(k) plan within your company. You will then roll the money from your current/old 401(k) into the new 401(k). You can then use the money in your new 401(k) to purchase the shares of your company. This will give your business cash to get started, and your 401(k) will own shares of your company.

Step 3b: IRA funds – Ask IRS for permission

You will have to ask the IRS to approve the purchase of shares in the C-Corp. They are not friendly with these purchases, so it can be a big hoop to jump through. Once approved, you will purchase shares of your company with the money in your IRA. In order to make this purchase, your IRA custodian will have to approve it (some of the major custodians will turn you down). This means transferring the IRA to a self-directed IRA with a new custodian that is friendlier to these types of transactions.

Other important considerations

The IRS prohibits “self-dealing” in retirement accounts. This means you can’t be the primary benefactor of investments made by your retirement accounts. This strategy avoids this rule by investing in a start-up company, so you can’t do this for an established company.

Please understand that according to the IRS, most businesses fail to implement the strategy correctly and thus risk their retirement plan losing its tax exempt status. This means the entire balance of the retirement account is taxable plus a 10% penalty if you are under 59.5 years old.

Expect to spend $5,000+ to establish this strategy, and several thousand more each year to continue it. You will be required to have the company appraised annually to value the shares of your firm now owned by your retirement account.

This is a very risky decision. If you are depending on the company for your income, and you have now tied up your ability to retire in it as well, you are going to be very undiversified. Be sure you have a Plan B in case something goes wrong.

Thanks to Jeff Rose, Cathy Curtis, and John Park for their previous work on this topic.

For more technical information, you can view the IRS information here: http://www.irs.gov/pub/irs-tege/rne_fall10.pdf

Alan Moore is a fee-only financial planner and founder of Serenity Financial Consulting in Shorewood WI. Follow him on Twitter @R_Alan_Moore. You can contact him at alan@serenityfc.com, 414-455-5313, or visit his website at www.SerenityFC.com. Want more education? Download your free guide to the “10 Easy Steps To Securing Your Financial Future Today.”