Financial Roulette

Is borrowing from your IRA a healthy risk or a tragic mistake?

Magazine Contributor

June 1, 2000 8 min read

This story appears in the June 2000 issue of Entrepreneur. Subscribe »

Courtney McCain, 25, is at once an unlikely and highly likely entrepreneur. She's got half a college degree. She married an Air Force man and moved to a remote base in the Midwest. After being re-stationed on the East Coast, she separated from her husband and moved nearer to family and friends, where she went through a string of administrative assistant jobs. She excelled at each job but was ultimately bored and burned out. Now an assistant account executive with a public relations firm, McCain is on a decidedly professional track.

Public relations might be her calling...but, then again, it might not be. "I know that I've got the brains and the talent to be a success," she says, "but it has to be on my terms. My big challenge is to find out what it is that I'm good at doing. Successful people aren't successful just because they're smart. I think they're successful because they've pursued things in which they have natural talent."

For McCain, what seems to come naturally is consumer sales. And to test the waters, she's taken on a distributorship for Mary Kay Cosmetics in addition to her 9-to-5 routine. There are few downsides. Besides, if this is her true calling, or at least a calling, there's a lot of upside potential.

But when opportunity comes knocking, it usually has a price. As a distributor, McCain buys her makeup products directly from the company and marks them up, generally 100 percent. To make, say, $2,000 in sales, she must fork over $1,000 upfront. To make $10,000, it costs $5,000 upfront. In short, during her nascent career as an entrepreneur, McCain has come up against one of the fundamental challenges of business: It takes money to make money. Unfortunately for McCain, due largely to her age and a near-Bedouin existence over the past three years, she doesn't have any money.

The issue cuts deeper than simply not having risk capital on hand for a new venture. For hundreds of thousands of would-be entrepreneurs like McCain, there's no access to funds, either. There's nary a bank in the country that would lend her a dime. She can get a debit card, but not a credit card. And in McCain's case, a fierce streak of independence keeps her from asking friends and family for a loan.

David R. Evanson's newest book about raising capital is called Where to Go When the Bank Says No: Alternatives for Financing Your Business (Bloomberg Press). Call (800) 233-4830 for ordering information. Art Beroff, a principal of Beroff Associates in Howard Beach, New York, helps companies raise capital and go public and is a member of the National Advisory Committee for the SBA.

Worth The Risk?

All this is why an idea as cockamamie, ill-advised and downright dangerous as taking money from your IRA, in certain circumstances, isn't such a bad idea after all. Although people will call you crazy if you even think of taking money out of an IRA to fund a business, there can be a gaping hole in the logic behind those people's complaints. In McCain's case, the lapse in the logic is that her IRA, funded with $1,000, is just about the only asset she has. She can scratch her head wondering where to get $1,000, or she can roll the dice, get on with life and perhaps make a lot more money that she ever could playing it safe.

Here's another reason for McCain to tap her IRA: Entrepreneurs who don't put themselves in some form of jeopardy to get their businesses off the ground often preclude the participation of other investors. Banks, family members and angel investors don't like to be the only ones at risk in the deal. The thinking goes, "If you're not willing to risk it, why should I?" Entrepreneurs who do take these kinds of risks often find that financial partners, would-be or otherwise, are much more receptive to financing proposals.

McCain, though not totally comfortable with the idea of drawing on her IRA, is doing it anyway. "I see it as a way to accelerate the process," she says. "I can plod along, or I can put my money where my mouth is." And, in truth, while raiding one's own pension fund simply can't work in a lot of deals-i.e., never use it to fund biotech research and development-it works beautifully for the rapid inventory turnover business McCain has chosen.

Once McCain finally gets her hands on her money, she can use it to get $1,000 worth of inventory. If all goes well, this $1,000 in wholesale goods will generate $2,000 in retail sales. As a result, she only has to sell half her inventory in 60 days and get it back into her IRA before she'll suffer any penalties. In fact, the wiser entrepreneurs might suggest that putting herself under the gun like that is the best thing that McCain can do to jump-start her business. The real beauty of the plan is that if she sells out her inventory and makes $1,000, she can finance her next purchase of inventory with profits rather than her nest egg. In short, by taking on some risk, McCain gets her assets to work for her.

Sticky Red Tape

You can't do any of this without the government getting into the act, however. Remember, IRAs let your money grow tax-deferred. To the fed's way of thinking, because they're allowing you to avoid capital gains taxes for some 60 years with your IRA, they have a say-so in what happens to the money in the meantime.

The rules and regulations pertaining to IRAs are covered in IRS publication 590, a mind-numbing tome with some 80 pages. But, according to Mike Busse, a senior vice president of Harris Trust & Savings Bank in Chicago, the mechanics are quite simple: "You can withdraw the assets from one IRA and use the funds for 60 days before redepositing them without creating a taxable event."

Such a transaction is called a "roll-over." Since most of the rules covering rollovers deal with the transfer of assets from one IRA to another IRA owned by the same individual, financial experts like Busse get just a tad uncomfortable with the idea of taking money out of one IRA and putting it back into the same one.

"When someone does use their IRA to, in effect, give themselves a loan, a transaction which it was never designed for, it might be safer to go from one account to another as opposed to a round trip in the same account."

The ultimate downside, if things don't turn out as planned, really isn't so bad-as long as you don't mind losing a little money. In the case of McCain, let's say she withdraws her $1,000 and promptly buys $1,000 of inventory. Further suppose there's a fire in the apartment next door, and her entire inventory is lost to water damage. Let's further assume that she has apartment insurance, but, alas, the settlement becomes protracted, and by the 60th day, she still doesn't have the money, and, worse yet, hasn't been able to make any sales because there simply isn't any demand for soupy rouge.

According to Busse, the IRS will levy a 10 percent penalty on the amount she withdrew, which in this case would total $100. In addition, the $1,000 early withdrawal would be added to her total income in the year in which she took it and subsequently taxed. If McCain happens to be in a 28 percent bracket, the failed maneuver would cost another $280 in income taxes. In sum, she'll pay close to $400 in penalties and tax, and she will have suffered a total loss on her retirement savings of $1,400.

This may sound like peanuts-especially to a risk-oriented entrepreneur-but Busse says that it could be quite expensive and financially dangerous for someone older with more assets involved. "What if the person involved wasn't 25, but 50, and the amount in question was $100,000 instead of $1,000?" If things go south, the penalty would be $10,000 and the taxes in a 34 percent bracket would be $34,000. "A loss like that so close to retirement could have a lasting impact on someone's quality of life during retirement," says Busse.

What should you take away from all this? Think hard about other alternatives before turning in this direction. But recognize that when you lack other options, sometimes there's more risk in playing it safe than there is in actually taking a risk. McCain has come around to this way of thinking. "If I lose all the money, it won't change my life one iota," she says. "But if I succeed, the sky's the limit."

Next Step

Visit www.irs.gov, navigate to "Forms and Publications" and download IRS Publication 590. With it, you'll have all you need to know about making a withdrawal from your IRA.

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