By Jim Cramer and Wally Konrad, former senior editor for Smart Money magazine
NEW YORK ( TheStreet) -- The ads are peppered throughout the Internet:
"Buy or start a small business using your retirement savings!"
"Finance a business or a franchise from your 401(k) -- without debt!"Players like Guidant Financial and IRA Financial Group have armies of advisers waiting to tell you how to use a little known tax loophole to redirect your nest egg into what may be one of the riskiest investments ever: a small business. The tax situation works like this. If you invest your 401(k) funds from a former employer to buy or start a business, you will be able to do so without the taxes and penalties associated with early 401(k) withdrawals. Instead you roll over the money into the business's retirement plan and use that money to invest in stock in the company. The rollover part means you avoid taxes and penalties. At the same time, buying the stock provides cash to start or buy the business.
The strategy only applies to C corporations (companies that are taxed separately from their owners), and you cannot use the 401(k) money to pay yourself or anyone else a salary. Keep in mind you can't roll over your 401(k) unless you have left your job. Funds from a 401(k) may be used to finance the entire purchase or start-up or can be used in conjunction with Small Business Administration loans and other financing. Like most tax dodges, this one is complicated. Most people who decide to use it pay a third party like Guidant or one of the other firms to help set up the new company's retirement plan and administer it each year. Guidant CEO, Jeremy Ames, says the company has helped 7,000 people invest in a business since it started 10 years ago. Most bought existing small businesses, while only a few clients use the strategy for start-ups. After two years, 86% to 94% of Guidant clients were still in business; after four years, 60% survived, according to Ames.
Impressive as that may sound, the truth is this strategy is only appropriate for a tiny percentage of 401(k) savers -- those who are wealthy enough to know they have enough saved for a comfortable retirement and sophisticated enough to buy a business that will thrive.