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Greg O’Brien, CPA, CTS
June 28, 2024

Investing in Startups Through Roth IRA

Growing financial demands under constant global economic shifts have increased the need for individuals to seek new ways of wealth generation and ensure their financial freedom for the future. While stocks, bonds, and real estate remain the traditional investment categories for wealth generation, individuals are now also considering alternative investment categories with the potential for higher rewards. A strategy that has got significant attention refers to investing in startups (usually venture backed C Corps) through a Roth IRA which in turn offers the opportunity to grow investments tax-free. From a company’s perspective, this could be a unique way to raise capital. For an investor, a way to unlock capital that otherwise is sitting on the sidelines.

Investing for tax-free wealth: The power of a self-directed Roth IRA

To understand the strategy it’s important to start from understanding what a self-directed Roth IRA is. A Roth IRA in general is an account in which post tax (after tax) money is deposited, up to certain IRS limits.  If you follow the basic requirements, when you distribute funds from the account in retirement, there will be no tax on the earnings.  Compare this to a pre-tax or Traditional IRA account where the funds are taxed on the way out at the current effective rate. 

A self-directed Roth IRA refers to a retirement account that allows you to invest in alternative assets such as real estate, private equity, promissory notes, and even startup companies. In fact, at Anomaly, we have had clients invest in livestock!  There are limited expectations of what you can invest in. 

This type of account puts you in total control of your investment decisions and opens you to lucrative opportunities, especially when it comes to penetrating the startup ecosystem where the potential for greater returns lies.

Peter Thiel, former CEO of Paypal, grew his Roth IRA from $2000 in 1999 to a 5 billion dollar tax-free retirement account. His personal story and after his case, close to 8000 more taxpayers as identified by the U.S. Government Accountability Office using 2011 tax data, with Roth IRA balances exceeding $5 million, serve as a testament to the potential benefits of investing in startups through utilizing self-directed Roth IRA.  There is considerable risk with this strategy and you cannot self-direct a Roth IRA into your own startup in which you have equity or managerial control.  For further insights here, the IRS has substantial literature on “self-dealing”. 

The benefits of Roth IRA: Investing in startup opportunities

Several benefits present investing in startups through a self-directed Roth IRA as a lucrative opportunity and the main ones include:

  • Tax-Free Wealth Growth: Gains and profits generated from startup investments within a Roth IRA are not subject to capital gains taxes or ordinary income taxes. Taking this into consideration, one does not have to worry about tax implications related to their potential gains.
  • Tax-Free Withdrawals: All funds can be withdrawn from the Roth IRA tax-free during retirement. While traditional IRAs face taxes on withdrawals, Roth IRAs allow for full access to the funds without tax burdens, provided that you meet certain criteria.
  • Portfolio Diversification: Startup investments using a Roth IRA allow for the diversification of asset classes beyond traditional asset classes. While alternative asset classes such as startups might have higher risks associated, they also have the potential for significant wealth creation that cannot be met within a traditional public market. 
  • Generational Wealth Creation: Investing in startups through self-directed Roth IRAs beyond presenting a viable option for high returns on investment, can also lead to generational wealth creation which goes beyond supporting your retirement goals.

How to invest in startups through Roth IRA

While there are some unique benefits to this strategy, there are multiple steps to be taken to set up this type of account properly.  We always recommend working with both your financial and tax advisors on this process. 

  • Create a self-directed Roth IRA account: First, you need to open a self-directed Roth IRA! Many traditional financial institutions still do not offer services for self-directed Roth IRAs! If that’s the case, it’s important to research several reputable custodians and brokerage firms that have the expertise in opening these accounts and select one that aligns with your investment goals and also supports you when it comes to investing in startups. 

  • Deposit to the account: The second step would be to fund or roll over funds into the established Roth IRA account. Note that it’s important to comply with the regulations imposed by the IRS and it’s encouraged to consult with a tax strategist to avoid any potential penalties or additional taxes if you are over the income limits.  

  • Research and identify promising startups: Researching to identify startups within your personal network or with the highest potential to grow and expand which in turn would result in higher returns on investments makes up the most important step of this strategy. Taking into consideration the different natures of the startup projects, it’s advisable to seek counsel from experts within the particular asset class. 

  • Make the investment: Upon concluding your research you can initiate the investment process which usually goes through the custodian of your self-directed Roth IRA who can facilitate the process on your behalf, and it’s important to follow the necessary procedures to ensure a smooth investment process. 

  • Monitor and evaluate: Lastly, one of the key elements to ensuring the success of your investment strategy is to put in place your monitoring and evaluation techniques to stay informed about the progress and developments of the startup you’ve invested in. Among the key strategies include reviewing financial reports, attending shareholder meetings (if possible), and staying in touch with the management.  However, these are long term plays and an investor using a Roth account should remember that the access to cash will be tied up for quite some time. 

Key considerations and rules for startup investing with a Roth IRA

There is a set of rules and considerations that you should be aware of when it comes to investing in startups through self-directed Roth IRAs:

  • Prohibited Transactions: The IRS has in place a set of rules that prohibit certain transactions within self-directed IRAs and it’s crucial to understand the circumstances that can result in penalties or taxes.
  • Qualified Custodian: Your custodian of the self-directed Roth IRA plays an instrumental role in supporting, guiding, and assisting you in ensuring compliance with IRS regulations, and hiring a qualified one plays a definite role in this department.  Traditional custodians will not offer this service, so we recommend that you talk to your CPA about the best self directed custodians they know. 
  • Diversification: Aim for a diversified investment portfolio by allocating proportions to different asset classes to reduce risk and ensure stability is considered important. 

Putting it together

Roth IRA startup investments present a lucrative opportunity to generate tax-free wealth which can also become generational. In addition, this approach not only offers tax-free wealth growth but also provides a pathway for portfolio diversification. With careful planning and adherence to IRS regulations, this strategy can potentially lead to significant long-term financial benefits, all of which could be tax free.

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