Are you thinking about borrowing from your 401(k) to fund a business plan?
As you probably know, the basics of the 401(k) plan are actually really simple.
You set aside a portion of your paycheck each pay period. The money you set aside is NOT TAXED. Then, you take that money and tell your 401(k) plan person where and how you want it invested. You only pay taxes later, when you retire and start withdrawing the money. The money you have set aside is growing tax free. So, you are starting off with more money to invest. Depending on your employer, you may also receive matching contributions.
This combination of the money you set aside plus your employer’s contribution will continue to grow tax free. That’s part of the BIG BENEFIT of the 401 (K). Tax free investing up until you retire. Then you only pay taxes on the amount you are withdrawing during your retirement.
But, what if you want to “borrow” some money now to fund a new business you are starting on the side. Is this a good idea?
Perhaps, but you have to understand the potential pitfalls as well as the advantages.
You are borrowing from yourself. Most plans allow you to borrow a percentage of your balance. A common ratio is 50%. You do need to remember that this is a loan, and there is interest on this loan. But get this, the interest you pay is to yourself.
The interest rate on a 401(k) loan is often better than you can get with a consumer loan and certainly much better than any credit card cash advance loan.
The loan repayment comes right out of your check, just like your regular 401(K) contribution.
The loan can be a good source of start up capital for a new business.
If your new business is profitable, you may earn a higher return with the business, than you would with that money in a 401(k).
Every day you are not “in-the-market,” there is the potential for missing out on market gains. This is important for a number of reasons. What if your 401(K) was only invested in an index fund, like the S&P 500 funds that are common nowadays, and you took out a 3 year loan against your balance. What if the S&P index increased significantly over those same three years? Guess what?
YOU LOSE! Actually you lose twice. First, you lose on the gains from the 3 year rise in the S&P 500 for the amount of money you have “pulled out” for your loan. Then, KAPOW! You lose again over the next 20 years for the compounding effects of those gains. Ouch! Can you see the quandary here?
Should your new business lose money or even ultimately fail, you still have to repay your loan.
Should you lose your job, you still have to payback the loan. If you can’t repay the loan, our friends at the Internal Revenue Service (IRS) will call this an EARLY DISTRIBUTION. That’s very bad. You will have to pay both a tax on this early distribution and a penalty for early withdrawal.
What Does This Mean?
Bottom line…there is NO one right answer. Sorry, but there is no EASY button to push for the correct choice. Unfortunately since most of us don’t have access to a reliable crystal ball, we don’t know if our business idea will prosper or fail. Likewise, we can’t predict future market returns. So, you will need to very carefully look at your idea for a new business before you decide to borrow against your 401(k).
Is your new business idea a proven business model such as a franchise? Or is it something you are starting yourself from scratch? Neither one is better than the other, although a franchise may be more predictable. At the end of the day, look carefully at your business idea, look at your own personal tolerance for risk, then move ahead.
Have you borrowed against your 401(k)? How did that work out?