How do I get my 401(k) money out to start a business without being taxed on it? I must get this question at least twice a week, so it’s about time I answer it here on my blog. There are two possible ways to do this. The first is to borrow out whatever you are allowed by your company. Normally this is 50% of the value of the account. This is my preferred solution to this question.

Helena asks about the other possible solution.

Q: Can I set up a pension plan in a new C corporation, then roll my 401(k) into that C corporation and have the pension plan buy stock in the C corporation?

A: Potentially, yes. I say potentially because the IRS recently has been attacking this transaction. There are several companies who will set this up for you. Technically, it should work. The IRS is attacking it under their broad powers of collapsing transactions that only have a tax purpose. The new health care bill signed last week by President Obama includes a provision that may make this attack even easier for the IRS.

In that bill, the “economic substance” doctrine, which has been around for eons of time in the courts, was added to the Internal Revenue Code. The essence of this law is that if you cannot show a substantial non-tax purpose for the transaction, then the IRS can ignore the transaction. The fines they can impose are enormous – 40% of unpaid tax with no relief possible unless you can win your economic substance argument.

I am not a big fan of this transaction for many reasons. First, the obvious potential for the IRS to reverse it and assess penalties. Second, you now own your company through your pension plan, so when you eventually sell your company, all of the distributions will be taxed at ordinary income rates.

Third, the company is subject to tax on all of its earnings currently at corporate tax rates that reach as high as 35%.

So, I would suggest you either borrow out the money or pay the tax now on the distribution.

Warmest regards,

Tom