Should a non-founder buy startup stock with an IRA?

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After I posted an article about Peter Thiel’s $5B Roth IRA a couple weeks ago, I had a handful of readers reach out to me asking if this was something that early employees could also do. It’s an interesting question, for sure: if this can be such a huge tax windfall for founders, can other enterprising startup employees benefit from the same strategy? The only way to know is to break it down.

Am I eligible to do this?

The first question, and the more useful qualifying question is probably just: can you even go and execute this strategy at all? The short answer is: maybe. The longer answer is that there’s probably nothing that makes it illegal for an early employee to exercise their options or purchase restricted stock through a Roth IRA. It’s extremely unlikely that, as an early, non-founder employee, you are a 50% shareholder in the business, which would, decidedly, make you a disqualified person under the US Tax Code, and prevent you from being eligible to purchase your stock with an IRA. Most venture-backed companies are also structured as C-corporations, which is also copacetic with purchasing via an IRA. If, for some reason, your company is an S-corp, you won’t be able to do this, since IRAs cannot be shareholders of S-corps.

Now, just because you can do it legally doesn’t mean your company will allow you to do this. Logistically, you can purchase private company stock using a Self-Directed IRA (SDIRA), but in order to actually complete the transaction, the company has to be willing to accept investment from the SDIRA. If you can convince your company that this is a sane, rational thing that makes sense, and doesn’t create a legal burden on them, then you’re probably in business!

How do I get enough cash into my Roth IRA to buy this stock?

Holding off on the meat of whether or not this maneuver makes sense, for a moment, one big question is: how do you actually stockpile enough cash to purchase your equity with a Roth. Roth IRAs have a contribution limit of $6000 per year, which is not a huge amount of money, from the frame of reference of stock option exercises. Realistically, there’s probably a couple different answers to this question:

Join early enough that your stock costs next to nothing

The earliest employees of a venture-backed company are usually joining around a Seed or Pre-Seed funding. What’s a little bit unique about these stages, as compared to the lettered rounds (A, B, C, etc.), is that Seed rounds are frequently done with convertible debt or SAFEs (Simple Agreement For Equity, popularized by YCombinator). These rounds are typically done by promising investors equity in the future, which means they happen before a price is actually set for the company’s equity. As a result, the price of shares at this stage, for founders and employees is usually $0.001 or $0.0001 per share. Which means 1% of a company that has 10M shares outstanding (which is where companies typically start) will cost $10-$100.

Convert a traditional IRA or make Roth contributions to your 401(k)

Another option for padding your Roth is to convert a traditional IRA to a Roth IRA. This is a pretty standard financial process these days, though you’ll likely want to enlist a CPA to help with it. If you have a traditional IRA lying around (often rolled-over from an old 401(k)), you can convert it to a Roth IRA, but you’ll have to pay income tax on the converted funds, which will happen at your current tax bracket. The other option is to make Roth contributions to a 401(k). Not every plan allows this, but I’ve seen it available at several of my last companies, so my guess is that it’s not terribly uncommon. The upside to this is that there’s no major tax hit (you’re still paying income tax on the funds that go in, but it’s coming out of your paycheck, so it feels a little bit less surprising), and the limit on annual contributions is $19,500, since this is a 401(k). 

Is there a benefit to buying your stock with an IRA?

The real crux of the question is whether or not this strategy actually makes sense for an early employee. Rather than keep you in suspense, I’m going to come out the gate and say “this is probably a bad idea.” However, far be it from me to drop the punchline and move on. The easiest way to rationalize this is to work through some scenarios.

The answer centers around Qualified Small Business Stock

Section 1202 of the US Code defines something called Qualified Small Business Stock, which has a handful of different requirements, but presents a huge tax windfall to founders, early investors, and early employees. Roughly, those requirements are:

  1. The company must be a C-corp

  2. You must be acquired at original issue (e.g. purchased the stock directly from the company via a funding round, or exercise of an option grant)

  3. The company must have less then $50M in assets at the time of the stock purchase (usually true until the company raises a funding round of $50M or greater)

  4. The company’s primary business is developing software (there are lots of other ways to qualify, but for the purpose of tech companies, this is probably the simplest distillation)

  5. The stock is held for five years or more

If the company meets all of these requirements, you can exclude up to $10M in gains from federal tax. That’s a huge tax exclusion, but you’ll only benefit from it if your stock is held outside of a Roth IRA. If you think you’d want to use those gains in the near term (to buy a car, a house, a trip on Virgin Galactic, whatever), you’d need to hold the stock outside of a Roth IRA.

How long until 59 ½?

Any capital gains generated in a Roth IRA have to stay in the IRA until you hit 59 ½ years old. If you withdraw funds early, you’ll have to pay income taxes and a 10% penalty on the amount, which kind of defeats the whole point. Most Seed investments will take somewhere in the range of 5-10 years to really mature, so the time horizon for these investments is a little bit different than a standard retirement time horizon. The closer you are in age to 59 ½, the less time you’ll have to wait before you can start leveraging those gains, so there might be more of a justification if you think you can clear $10M in gains and you’re in your 40s or 50s. In your 20s or 30s, the money is likely to have more near-term value for buying a home, or making it easier to leverage the income for things other than traditional investments.

Will you clear $10M in capital gains?

This particular question is why I think that it’s a little insane for anybody other than a founder to attempt a Peter Thiel special. Let’s assume you’re the first employee. And a key employee at that! If you join a company that is extremely generous, maybe you get 4% equity upfront. In the span of the five years it takes for your equity to qualify for QSBS tax treatment, we might see four new rounds of funding, and let’s assume this company is doing really well, and averages 15% dilution in each round. At the end of the five years, your equity is diluted to about 2%. In this extreme circumstance, the company would need to be worth $500M in order for you to cross that $10M gains threshold. It’s potentially worth a reminder that it is a) unlikely an early employee would get quite that much equity, b) even less likely that every round would happen swimmingly, and c) the vast majority of companies never even get to the A round. Unless you can reasonably claim that there is a path to a $10M outcome for you, just get a good CPA and stick to claiming QSBS.

What if you’re an exec with a big stock package?

If you’re an executive, and receiving a package where $10M is actually a rational outcome, the question probably shifts to whether or not you can actually afford to purchase your equity with a Roth IRA. This might actually be possible if you’ve packed your Roth full of dollars, or have been planning this move for years, and have been making Roth 401(k) for years. I think the question here probably turns towards asset allocation strategies, and whether or not the risk profile of having your retirement heavily invested in a high-risk asset makes sense. I’m all for putting riskier assets into tax-deferred and tax-advantaged accounts, so that you can get more value from the tax treatment, but it’s one thing to buy growth ETFs, and an entirely different thing to use a retirement account for an asset that could, realistically, go to zero.

This strategy is probably not worth the trouble for employees

As alluring as it might sound to get a massive tax break like the PayPal founders, the amount of effort you’d have to go through as an employee is probably not worth the effort. You might be able to squint and make it make sense if you put some of your stock into a Roth, and kept some outside to take advantage of the QSBS treatment, but even so, you’re not likely to get the maximum benefit from either, without having founder levels of equity. It’s probably best to save this one for the crazies.