Investing in Startups Through a Roth IRA

The money that you contribute to your pension doesn’t necessarily have to be invested in just stocks, bonds, and active and passive funds. If you’re feeling especially brave, consider opening a self-directed Roth IRA. These individual retirement accounts permit you to stake your future on more exotic asset classes, including precious metals, real estate, cryptocurrency, and startups.

The startup Roth IRA combo made headlines in 2021, when it was revealed that PayPal co-founder Peter Thiel’s meshing of the two turned just under $2,000 into a $5 billion tax-free windfall. This news reminded investors not only that they can use a Roth IRA to invest in startups but also that the benefits of doing so can be enormous.

Key Takeaways

  • With a self-directed Roth individual retirement account, it’s possible to invest your after-tax dollars in startups and withdraw everything tax free in retirement.
  • Plenty of companies offer the opportunity to invest in startups via a self-directed Roth IRA, although you may not recognize many of them.
  • Choosing the right custodian is important. Consider whether you would prefer to save on fees or pay more for great service and assistance.
  • Before making an investment, make sure that it doesn’t breach Internal Revenue Service (IRS) rules or trigger extra taxes.

How to Invest in Startups Through a Roth IRA

You can begin investing in startups through a Roth IRA by following these steps:

Open a Self-Directed Roth IRA

The first step is to open a self-directed Roth IRA. These accounts are offered by brokerages, just like any other type of IRA. However, many of the big-name firms don’t tend to offer self-directed Roth IRAs to clients, perhaps because of the risks involved or because it’s harder to profit from them.

Fortunately, there are plenty of other companies that can act as a custodian to your account. Your job is to identify them, do your due diligence, and decide which one is best for you.

This is a personal choice. Some people want to keep fees to a minimum, while others are happy to pay a little extra in return for better service. You’ll need to weigh up various factors, including costs, platform usability, customer service, and range of investments offered—a few self-directed Roth IRAs just specialize in a specific asset class.

Self-directed Roth IRAs are governed by the same contribution and withdrawal laws as regular Roth IRAs.

Fund the Account

After you open the account, you’ll need to fund it. This can be achieved by either making a fresh cash deposit or transferring or rolling over funds from an existing IRA or employer-sponsored retirement plan.

Start Buying

Now comes the hardest part: deciding how to invest your money. The “self-directed” part of self-directed Roth IRAs means that the custodian cannot give financial advice and merely acts on your orders.

Most people who have made it this far probably have a very clear idea of what they want to invest in. If that isn’t the case and you don’t feel confident about picking your own investments, you can always pay a financial advisor to help you. Investing blindly in startups is definitely not a good idea, so if you don’t have a clue what you are doing, look to bring in somebody else who has the right expertise and qualifications.

Once you have decided on an investment, you’ll need to submit an Investment Authorization form. This basically identifies the asset and instructs the custodian to make the purchase.  

Think carefully before embarking on this strategy. Investing in startups can be very lucrative but can, more often than not, end in misery.

Special Considerations

Before choosing where to park your money, you’ll also need to consider the following:

Prohibited Transactions

Self-directed Roth IRAs can offer a choice of assets beyond your wildest imagination. However, there are certain things you cannot do, known as prohibited transactions.

Specifically, the Internal Revenue Service (IRS) doesn’t allow self-directed IRAs (SDIRAs) to invest in life insurance, collectibles, or S corporation stocks. To ensure that you don’t have an unfair advantage over other investors, rules are also in place to prevent—as the IRS puts it—“any improper use of an IRA account by...any disqualified person.”

There are detailed rules of what is and is not permitted, and who can do what, and it’s important to learn them. For example, if a disqualified person—which includes yourself, your spouse, your descendants and their spouses, your financial advisor or other fiduciaries of your account, and certain business partners—is caught borrowing money from the plan, selling property to the plan, or using the account as collateral for a loan, then the punishment can be severe. The IRS has a zero-tolerance policy toward such behavior and will not hesitate to strip you of the account and distribute the money to you without warning, putting you on the hook for an early withdrawal penalty and potentially other charges.

Unrelated Business Taxable Income (UBTI)

Another thing that likely won’t affect you—but is worth being aware of—is unrelated business taxable income (UBTI). If a tax-exempt entity regularly engages in business unrelated to its primary purpose to make some money on the side, and if you invest in it with a self-directed Roth IRA, then you may be liable to pay tax on those particular revenues.

The IRS states that if a Roth IRA earns $1,000 or more of UBTI in a year, then the amount above $1,000 is taxable.

What is a self-directed Roth IRA?

A self-directed Roth IRA is a Roth individual retirement account that lets you invest in a variety of alternative investments. These accounts are administered by a custodian or trustee but—as the name implies—directly managed by the account holder.

Which self-directed IRAs (SDIRAs) let you invest in startups?

Quite a few companies offer this service. Examples include AltoIRA, RocketDollar, and New Direction Trust Co.

Can you make money investing in startups?

Yes, you can generate considerable returns on your capital if you get in quickly on a great idea—as early investors in Airbnb, Instagram, and Uber will attest. However, it’s not easy to make money from startups. For every success story, there are thousands of startups that fail to turn their ideas into a viable business.

The Bottom Line

If you’re keen to invest in startups, using a self-directed Roth IRA makes a lot of sense. Should things pan out the way that you hope, a small initial investment on which you paid income tax in advance could develop into a tax-free fortune for your retirement.

As with any investment, though, it’s important to be calculated in your approach. Don’t just jump in with the first self-directed Roth IRA custodian you come across, and contact a tax or financial advisor if you have any doubts. When investing in startups, the odds of making money are stacked against you. The last thing you want is to lengthen those odds even further—especially with the money you’ve set aside to fund your retirement.

Article Sources
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  1. ProPublica. “Lord of the Roths: How Tech Mogul Peter Thiel Turned a Retirement Account for the Middle Class Into a $5 Billion Tax-Free Piggy Bank.”

  2. Internal Revenue Service. “Retirement Topics — Prohibited Transactions.”

  3. Internal Revenue Service. “IRA FAQs: Investments.”

  4. Internal Revenue Service. “Publication 560: Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans),” Pages 20–21.

  5. Internal Revenue Service. “Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs),” Pages 31–32.  

  6. Internal Revenue Service. “Unrelated Business Income Tax.”

  7. Internal Revenue Service. “Publication 598 (03/2021), Tax on Unrelated Business Income of Exempt Organizations.”

  8. U.S. Securities and Exchange Commission. “Investor Alert: Self-Directed IRAs and the Risk of Fraud.”

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