When Should You Use – or Not Use – Your 401(k) To Fund a Small Business?
People who were born with the gift of the entrepreneurial spirit don’t need vision, drive, determination or good ideas — but they almost always need money. A lot goes into starting a business and every business starts differently, but they all have one thing in common — without money, there’s no getting started at all.
If you’re finally ready to take the plunge from W2 wage earner or independent contractor to a full-fledged business owner in 2022, you may or may not even be aware that you might be able to borrow money from your own retirement fund.
“Can” and “should,” however, are two different things. Before you even consider giving yourself a loan from your 401(k), make sure you know what you’re getting into.
Before You Get Your Hopes Up
Borrowing from your 401(k) is certainly not right for all business ventures, but if your credit is spotty, if you’re overextended, or you’re otherwise having a hard time securing traditional financing, just having the option can feel reassuring.
The problem is, not every 401(k) is eligible. Some plans don’t allow for any kinds of loans, business or otherwise, but many do. Consult your plan documents or ask your plan administrator, HR contact or your boss.
How Do 401(k) Loans Work?
If you are allowed to borrow from your plan, IRS regulations allow you to borrow only up to $50,000 or 50% of your vested balance, whichever is less. An employee with $40,000 could borrow up to $20,000.
Different plans have different rules for repayment, but according to Forbes, you’ll generally have up to five years to pay back the amount you borrow. You must make payments at least quarterly and pay interest at a rate of at least prime.
It Might Just Be the Most Tax-Efficient Way To Borrow
401(k) loans are one of the only ways to access your pre-tax retirement funds without incurring a penalty or paying a tax, according to Forbes. Not only are you likely to get a better interest rate than you would with a traditional loan, but the interest you pay goes back into your plan, although that interest is never tax deductible, no matter how you use the money.
One of the other great things about 401(k) loans, according to FINRA, is that you usually don’t have to explain why you need the money or how you plan to spend it — try keeping those secrets with the bank.
Things To Consider Before Gambling Your Long-Term Financial Security
According to Entrepreneur, about 20% of businesses fail within the first year. Half fail within five years. Failed businesses bring financial turmoil, and financial turmoil makes loans hard to repay — but your 401(k) loan will never make it that far.
According to the Chamber of Commerce, if you leave your job, you’ll either have to repay the loan or suffer the consequences of early withdrawal tax penalties. Also, you can’t contribute to your 401(k) or receive company-match funds until you pay yourself back. Even if you do pay everything back as you should, keep in mind that you’ll be replacing what you borrowed with after-tax dollars, which will be taxed a second time when you start making withdrawals from your 401(k) in retirement.
The Chamber recommends that you borrow from your 401(k) only as a last resort and only for short-term obligations that you know you’ll be able to repay in a timely fashion.
Finally, if you’re considering borrowing from your 401(k) to start a business — or for any other reason, for that matter — it is imperative that you consult a financial professional and/or attorney who specializes in this niche before you make your move. You’re leveraging your future financial security — take it seriously enough to ask for help.
More From GOBankingRates