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Tax Guru-Ker$tetter Letter
Wednesday, April 28, 2004
Invest In Yourself
A common scenario I have seen countless times. A person leaves the employ of a large company (sometimes voluntarily and sometimes not) and has a very substantial amount of money in the former employer's retirement plan. This is a very tempting source of money to use to start up a new business or expand an existing one. Unfortunately, if the person is under 59.5 years old, there are heavy penalties (10% Federal plus something for State) for touching that money. Added to the Federal and State income taxes, I have frequently seen the effective rate on such withdrawals exceed well over 50% of the account balance. I have normally advised people to roll their retirement funds into an IRA account and then take out an equity loan against their real estate in order to avoid the huge tax and penalty hit.

Once cash and stocks are rolled over from a company plan to an IRA, there is still a question as to how to invest that money. Most people think that the only options are cash and stocks. However, the options are wider than that. We have long used the concept of "prudent investments" to designate what are suitable for retirement accounts. Some things, such as collectibles, are statutorily ineligible investments. I can remember about a dozen years ago, when the prices for ostriches and emus were escalating and promoters were claiming that those birds were suitable investments for IRAs and other types of retirement accounts. As I predicted back then, the market prices for those flightless birds collapsed and anyone stupid enough to fall for that get rich quick scheme saw their retirement nest eggs fly away.

About a week ago, I received an email from a reader referring to a company in San Diego, BeneTrends, that has established a certain type of retirement account, called Entrepreneur Rollover Stock Ownership Plan (ERSOP), where the funds are invested into shares of stock of closely held C corporations. S corporations do not qualify; one more benefit to using a C instead of an S.

This actually addresses a couple of very big problems that I have discussed over the years; how to safely invest retirement funds and how to obtain working capital for small businesses.

Safe investments of retirement money. I have long ridiculed people who invest their retirement money in super risky stocks. I have frequently had the unpleasant task of informing people that, because their retirement accounts were pre-tax money, which give them a cost basis of zero, there was no deduction allowed for the losses they suffered in those accounts.

Whether it's a dot-com stock, fueled by pure speculation frenzy, or what are considered to be blue chip stocks, I have never been a big fan of playing the stock market because you have no control over the management of those companies. Recent corporate accounting scandals have illustrated how valid those concerns were. Investing in your own company fixes that problem. If you end up losing the money, you only have yourself to blame.

According to the service fee schedule I was sent, BeneTrends charges $4,000 to establish the ERSOP plus a $700 IRS User Fee to register the plan, and annual maintenance fees of $800 plus $40 per participant. While at first blush, this may seem like a lot of money, it is a small fraction of the taxes that would be payable if the money were withdrawn from the account and used directly. It is also much less than the fees routinely charged for small business loans. I have also seen small companies pay well over $10,000 to establish more conventional defined benefit retirement plans; so $4,000 is quite reasonable. BeneTrends also offers incorporation services for $800 plus the state fees; but I still think my earlier suggestions for setting up a new corporation are the best way to go.

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