IRAs: Reason to use an IRA to make angel investments

Why would you want to make angel investments through an IRA rather than just cash?

  • Tax efficiency: gains made in IRAs have favorable tax treatments.

  • Other things to buy: People have plenty of ways to use their cash, for both investments and consumption. Uninvested capital in an IRA has fewer options!

  • Patience: Angel investing requires patience and a reasonable timeframe – 3-5 years if your investment thesis is “early exits”, likely much longer if you’re swinging for IPOs. If you have a capital source that must be patient, it could be a good fit for angel investing.

But does it actually make sense to use your IRA? 1. Investment considerations

We’ll skip the general reasons for making early-stage investments, from being not correlated with other asset classes, having the potential for out-sized returns, and the local development, networking, and other ancillary benefits. Here we cover whether it makes sense to use IRA funds to make angel investments you are already planning.

First, how you view your IRA funds determines whether you think using them for angel investing is sensible.

  • If they are absolutely critical to your retirement and you cannot afford to lose them, you should not use them for angel investing, because you could lose it all. Of course, you could lose it all investing in public equities too if picking individual stocks, and you can diversify in angel investing too; but, still, the chances of losing significant capital are real.

  • If they are more discretionary – great to have, but available to be used to try to generate some investment returns on a higher-risk, higher-reward strategy – you might want to use them.

Second, timing and liquidity are important. Angel investments are hard to sell, with little you can do to create “liquidity” (i.e. turn them back into cash) if needed. That’s good: if you have a long-term horizon for these funds, an IRA is a good place to invest from; but it’s also bad because you have to make required minimum distributions (RMDs), having assets that are hard to sell creates complications.

You can make distributions from IRAs as “in-kind” distributions (i.e. you can distribute the stocks rather than selling them). There is more planning you can do around this too. But still, it can be complicated to distribute shares at “market value” when that value is hard to judge.

(And risky: if a valuation has gone up from later rounds you might have to pay ordinary income on the phantom increase in value, only to see the value disappear if the company ultimately fails.)

So, with some careful planning, and especially if you have some time before RMDs (these, not this guy) kick in, using IRA funds you can afford to lose can make sense for angel investing.