Investing in Startups Through a Roth IRA

The money 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, you can consider opening a self-directed Roth IRA. These 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 the 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.

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, although many of the big-name firms don’t tend to offer them to clients, perhaps because of the risks involved or because it’s harder to make money out of them.

Fortunately, there are plenty of other companies out there 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, the usability of the platform, customer service, and the range of investments offered—a few self-directed Roth IRAs just specialize in a specific asset class.

Fund the Account

After you’ve opened the account, you’ll need to fund it. This can be achieved either by making a fresh cash deposit or, alternatively, by 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. Self-directed Roth IRAs are self-directed, meaning that the custodian cannot give financial advice and merely acts on your orders.

Most people who’ve 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 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 somebody else on board who has the right expertise and qualifications.

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

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 you don’t have an unfair advantage over other investors, there are also rules in place to prevent, as the IRS puts it, “any improper use of an IRA account by a disqualified person.”

There are detailed rules of what is permitted and not permitted, and who can do what, and it’s important to learn them. 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, for example, borrowing money from the plan, selling property to the plan, or using the account as collateral for a loan, 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 you invest in it with a self-directed Roth IRA, 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, the amount above $1,000 is taxable.

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 you hope, a small initial investment that you paid income tax on 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 into bed 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 and the last thing you want is to lengthen those odds even further—especially with the money you’ve set aside to fund your retirement.