The first challenge of any VC investor, PE professional, or fund manager, in general, is to raise money from LPs. For fund managers looking for capital, we discuss in a previous post 20 channels to explore when sourcing new LPs. Of these 20 channels, the self-directed IRA is the one we get asked about the most.
What is an IRA? What are the different types of IRAs?
As a reminder, IRA stands for Individual Retirement Account. In short, IRAs provide a way for individuals to save money for retirement while reaping specific tax advantages, depending on the type of IRA.
The four common types of IRAs:
- Traditional IRA: where individuals make a pre-taxed contribution to their retirement plan and can generally defer taxes on the investment made through an IRA to when they retire. On top of having a more extensive capital base to be invested than if it had been taxed upfront, retirees are often in a lower tax bracket when they retire, effectively ending up paying less tax on their investment earnings.
- Roth IRA: where individuals use their post-tax savings to make contributions and benefit from tax-free earnings on investment and capital gains
- SEP IRA: an IRA for those who are self-employed or freelancers
- SIMPLE IRA: an IRA for small businesses that do not already have any kind of savings or retirement program set up. This is most similar to a 401(k) plan.
Self-Directed IRAs
Most IRAs hold traditional assets that are publicly traded, such as stocks and bonds. A self-directed IRA, however, allows individuals to invest their tax-advantaged savings into alternative investments like real estate, small businesses, and more. In turn, sponsors or VCs who raise capital can offer LPs the ability to invest IRA money into their offerings.
How big is the self-directed IRA market?
For context, as of 2021, the total assets of IRAs in the United States reached a value of 14 trillion U.S. dollars and are growing, according to Statista. This shows how attractive it can be for fund managers to tap into that source of capital. And according to the Retirement Industry Trust Association (RITA), self-directed IRAs represent 3% to 5% of total IRA assets. That’s a good, estimated range of $420 to $700 billion that fund managers could tap into.
So why would an investor want to leverage retirement money to invest in your VC?
An LP might want to use IRA funds to invest for the following benefits:
- They will benefit from the tax advantages associated with IRA that we mentioned earlier. They will either benefit from the deferral of tax or a tax-free increase in their wealth.
- Investing in Venture Capital provides self-directed IRA holders with more diversification of their retirement saving on top of their investment in traditional stocks and bonds.
- By tapping into their IRA money, investors have an increased deployable investment capital that they can commit to investing into your VC fund.
Most investment fund managers do not associate IRA with VC investment. This is because Traditional and Roth IRAs only allow funds to be invested into publicly traded stocks and bonds, preventing investors from putting their savings into privately held companies, such as venture capital.
These limitations do not apply to self-directed IRAs, which do allow investors to put their retirement money into non-traditional investments.
Is my fund qualified to accept retirement money from investors?
If you are a fund manager looking to raise money for your next VC round, you must be wondering whether you are eligible to collect IRA money and what process you need to follow to do so.
As a rule, a venture capital firm can accept retirement money from investors if the firm does not facilitate investments deemed "prohibited." You can find more details about prohibited behaviors and investments here, but in summary, IRA money should not be invested into:
- Disqualified persons (IRA's owner, their family, or any person or entity directly related to that person and with significant potential influence)
- Personal benefit (All income from IRA assets must be returned to the IRA.)
- Disallowed assets (Collectibles, Life insurance, S-corporations)
How can I start offering investors the option to invest with my VC fund using retirement money?
If you want to take the leap and are serious about tapping into the potential of a self-directed IRA to fund your VC fund, here are the three simple steps to follow
- Find a licensed custodian that your investors can use. This is one of the services that we provide at AET.
- Notify investors that they have this option. Most self-directed IRA owners need to be made aware that they can use their retirement money to invest in your fund. Pointing it out to your existing base of limited partners can also help you get additional funding from your existing base of investors.
- Investors then go through the custodian to fund the retirement portion of the capital call.
Generally, the IRA money is held with the IRA custodian. However, the funds are invested only upon the direct request of the IRA holder. A custodian-controlled structure like AET allows IRA owners to invest in alternative private assets, such as venture capital funds but requires the agreement of the custodian. If approved, the IRA custodian will proceed with the VC fund investment.
If you need assistance navigating the process to receive self-directed investment, or if you are unsure how to introduce this option to your limited partners, you can reach out to the AET team at any time, and our specialists will be more than happy to assist.
Conclusion
As with everything related to investment, there are a few rules to know and follow to allow an investor to invest through their IRA. But the complexity of these rules is low and should not be an obstacle to investing, especially when considering the tax upside provided to IRA investors.
As a fund manager, once you have gone through that process, you will quickly become familiar with the matter and be better armed to pitch it to your LPs. This puts you in an excellent position to benefit from IRAs as an additional source of capital.
