Many young aspiring farmers have worked for several years at off-farm companies that offer retirement plans. If an employee who wants to farm has been investing the maximum amount for 10 years or more, his or her retirement account can easily value $100,000 to $200,000 or more. Aspiring farmers have several options for taking advantage of these funds to get started in farming.
The worst option is to simply cash out the retirement plan. The primary detriment to this option is the extra 10% penalty charged on top of any regular income taxes owed on the distribution. These income taxes reduce the amount of capital available for farming.
For example, if a farmer cashes in a $50,000 pension and assuming a 25% tax bracket, his total income taxes including the penalty would be $17,500. This leaves only $32,500 to use for farming.
Section 179. However, if the farmer uses these funds to purchase equipment and has other earned income, such as wages, he will be able to claim Section 179 on the equipment bought to offset the income tax on the retirement plan distribution. The 10% penalty will still be owed (there are some exceptions for using the funds for education, medical use, home purchase, etc.).
Let’s assume the same case as above, but the farmer has enough wages from either a job or a spouse’s job to take advantage of the Section 179 deduction. In this case, the tax would be only $5,000 and the farmer would still have $45,000 available to invest in the farm.
Another option is to borrow from a retirement fund balance to invest in a new operation. An employee can normally borrow up to $50,000 for any reason (assuming he has at least $100,000 in the plan). These borrowed funds need to be paid back with appropriate nondeductible interest in a five-year period. However, if the farmer is using part of the proceeds to purchase a primary residence, the funds can be paid back during a period not to exceed 15 years. A benefit to paying this back to a retirement plan is that it is earning a guaranteed rate of return that could be more than the market interest rate.
On Your Own. If an aspiring farmer wants to leave his employment to farm full-time, he has a few more options when using retirement funds to establish his operation.
One option is setting up a corporation or limited liability company. Both of these entities can create a pension plan in which to roll over retirement funds. Once these funds are in the new plan, the farmer can borrow the funds as discussed previously.
Also, assuming a farmer has at least $250,000 that he is rolling over, he might want to consider having the pension plan invest its funds directly into the farm C corporation. This option is available to almost any pension plan hosted by a C corporation. However, there are many complex and harsh rules on how to correctly handle this investment. The primary benefit to this type of investment is that the money invested by the pension plan is 100% available to use in farming.
To take advantage of this option, however, the farmer will need to have professional help in both designing the plan and doing the annual accounting and reporting to comply with the Internal Revenue Service and Department of Labor rules. Professional help to set up the plan can easily cost $5,000 or more, and it can run at least $1,500 to comply with the annual reporting requirements. This is why it is important to have at least $250,000 in the pension plan to offset costs associated with these types of investments.
One final point to consider is that these funds are designed to be used for long-term retirement. Any of the options discussed can cause these funds to be substantially reduced if the farm is not successful.
In this economy, however, borrowing from a retirement fund can allow the farmer to get started on his or her operation much sooner than trying to borrow money from a bank.
Paul Neiffer is a tax accountant with Hansen NvO and author of the blog The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at email@example.com.
Top Producer, December 2010