Borrowing from a 401(k) to Start a Business
Borrowing from a 401(k) to start a business may seem like a fast way to fund your dream, especially if you’re short on startup capital.
But before you dip into your retirement savings, we believe it’s important to understand what borrowing from a 401(k) to start a business really means for your long-term financial health.
Keep reading for a breakdown of the risks, rules, and alternatives to borrowing from a 401(k) to start a business.
Starting a New Business May Be Risky
Let’s start at the beginning.
The ability to start your business is awesome, but it may be risky.
According to the U.S. Census Bureau, “On average, there are 4.7 million businesses started every year.”¹
That number has been even higher in the last few years.
The data from the U.S. Census Bureau shows “a record-breaking 5,481,437 new businesses were started in 2023.”²
Based on historical data, most of these businesses will not be around 10 years from now.
Consider these statistics:
- 20% of new businesses fail within the initial 2 years.
- 45% of startups don’t survive past 5 years.
- 65% of new businesses fail within the first 10 years.
- 75% of American startups close down within 15 years.³
One of the main reasons new businesses fail is due to a lack of funds.
According to Forbes, “Data shows that 38% of businesses fail due to exhausting their cash reserves or the inability to secure additional capital. This points to the essential role of financial management in the survival and growth of startups and young companies.”⁴
This is likely because most new businesses get their funding from personal or family savings – and most Americans don’t have significant savings.
Hence, the reason many Americans are borrowing from a 401(k) to start a business.
Rules for Borrowing from a 401(k) to Start a Business
There are some companies that allow employees to borrow from their 401(k) to start a business.
If your company is one that allows 401(k) loans, there are rules set by the IRS.
According to the IRS, “The maximum amount a participant may borrow from his or her plan is 50% of his or her vested account balance or $50,000, whichever is less.”⁵
The IRS also requires the plan loan to be repaid within 5 years.
Additionally, 401(k) loans are paid back with interest.
Since you are basically paying interest back into your own account, many people see it as “borrowing from your own bank.”
But that isn’t really the case.
For instance, some 401(k) plans do not allow you to make contributions until the loan is paid off, which means your retirement funds are put on hold.
Unless It Is a Sure Thing, Don’t Do It
If you are considering borrowing from a 401(k) to start a new business, we recommend not doing it unless you are highly confident that…
- Your business will be successful.
- You will earn enough money to pay off your 401(k) loan within 5 years.
If you fail in either of these areas, chances are your financial future will suffer tremendously.
And that’s without considering the possibility of your plan not allowing you to contribute to your retirement during the payback period.
If you stop contributing to your retirement savings for 5 years, and then your business fails or you default on your loan, your financial future could be at great risk.
And, we haven’t even discussed the potential tax issues and penalties.
The Potential to Be Taxed Twice
When borrowing from a 401(k) to start a business, there are tax implications.
When you pull money from your 401(k), you are taking out pre-tax money.
But when you pay back the money to the 401(k), you are paying it back with after-tax money.
Plus, when the money comes out of the 401(k), it is taxed again.
This means you will be taxed twice.
Other Possible Penalties
In addition to being taxed twice, you must consider the potential penalties.
For instance, in order not to face penalties on the 401(k) loan, you are required to work at the company that sponsors your 401(k).
This means you must continue to work at your company while also trying to start and run a new business.
The U.S. Chamber of Commerce explains, “If you leave your job or your employment is terminated, you will have to repay the loan or pay the tax consequences of early withdrawal.”⁶
If you quit your job because it is too difficult to do both (run a new business and continue your current job), you most likely will be expected to pay back the loan even sooner.
This rule is also in effect if you get laid off or change jobs.
If you cannot repay the total loan balance, it will then be treated as an early withdrawal.
Early withdrawals have steep penalties – a 10% withdrawal penalty if you are under age 59½, as well as owing income taxes on the full balance of the withdrawal.
Use the 401(k) for What It is Designed For – Retirement
While you may be technically allowed to borrow money from your 401(k) to start a business, it is better to use your 401(k) for its intended purpose.
A 401(k) is designed to support you in your retirement years.
If you are borrowing from a 401(k) to start a business, you may be putting your retirement at risk.
For instance, if you are not allowed to contribute to your plan until you pay off your loan, you will miss out on compounded interest, as well as company matching.
Even if you are allowed to continue making contributions, you may find it difficult to pay back your loan and make contributions at the same time.
This means you can miss out on a good bit of money you could’ve earned and grown over those 5 years.
Alternative Funding Sources to Start a Business
Instead of borrowing from a 401(k) to start a business, look for alternatives.
- Ask around. Reach out to those you know in the business community or through your social media network for ideas about funding a new business.
- Consider a local bank. With a solid business plan, you may be able to get a loan from your local bank.
Check the Small Business Administration. The SBA offers many different types of programs that help with funding new small businesses. Visit the Small Business Administration website to see if there are programs which meet your business needs.
Find out what 401(k) Maneuver may do for your retirement account balance. Click below to book a complimentary 15-minute 401(k) Strategy Session with one of our advisors today.
SOURCES
- https://www.commerceinstitute.com/new-businesses-started-every-year/
- https://www.commerceinstitute.com/new-businesses-started-every-year/
- https://www.sellerscommerce.com/blog/small-business-statistics/
- https://www.forbes.com/advisor/business/small-business-statistics/
- https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans
- https://www.uschamber.com/co/run/business-financing/using-401k-to-start-a-business
