By Kelly Spors
Updated Feb. 13, 2007 11:59 p.m. ET

Q: I’ve heard different opinions about investing IRA or 401(k) assets to fund a start-up business. Can it be done without paying taxes and penalty on the invested amount?

A: Cashing out a traditional 401(k) or individual retirement account to fund a business will trigger a taxable distribution and usually a 10% early-withdrawal penalty if you’re under age 59½.

Some financial planners and third-party retirement-plan administrators, including BeneTrends Inc. and Guidant Financial Group, have devised a way around this problem using a little-known strategy that doesn’t involve cashing out. They set up a C corporation and establish a corporate retirement account. A person can then roll outside retirement accounts into the corporate plan and invest the money in the company’s stock. Since the person is buying shares of his or her own business, he or she is effectively feeding it money.

But this strategy only makes financial sense if a person is investing more than $50,000 of retirement money in a business, the companies say, because it costs roughly $5,000 to set up and about $800 in annual administrative fees.

The Internal Revenue Service has issued determination letters validating many of these plans. But a spokesman says “using retirement funds to invest in a start-up business raises a number of significant legal and procedural issues. The IRS is continuing to study these issues.”

Tax experts say there’s no IRS ruling authorizing the full process and this strategy seems to be capitalizing on a gray area in the tax law.

Many financial planners dissuade people from using too much retirement money as start-up cash. Many start-ups fail, so it’s often unwise to bet a nest egg on them.

Instead, look first to taxable savings and brokerage accounts for funding, reserving at least six month’s worth of emergency savings, says Jacob Gold, a certified financial planner in Phoenix. Then consider tapping home equity, through a credit line or refinancing. There also are loans from banks, friends and family. “The first thing we look to is any sort of nonretirement assets,” he says.

If you must tap retirement money, aim to do it as cheaply as possible. If you’re still employed, consider taking a loan from your 401(k) for up to $50,000. But keep in mind that the loan usually must be repaid before you terminate employment. If you have a Roth IRA, you can take tax-free and penalty-free withdrawals of all contributions to the account that are at least five years old. But you can’t replace the money after it’s withdrawn.