Should I Borrow from My 401(k) to Start a Business?
People often ask us about using their 401(k)s for different purposes, and one of the most common questions is, “Should I borrow from my 401(k) to start a business?”
This is an understandable question.
According to the New York Times, “From the second half of 2020 through May 2021, the Census Bureau tracked the highest number of applications to form businesses since the records started being kept in 2004.”¹
However, the vast majority (65%) of these businesses got their funding from personal and family savings.²
If you don’t have personal savings or family willing and able to help you start your new business venture, where will you get the funding?
Hence the reason many people ask, “Should I borrow from my 401(k) to start a business?”
Moreover, starting a business is a huge financial risk.
Forbes reports, “Hundreds of thousands of small businesses open and close every year. In addition, about 20% of businesses fail in their first year, and about half of all businesses close after five years.”³
When you ask, “Should I borrow from my 401(k) to start a business?” it means you are willing to risk losing financially on your new business and your financial future.
What You Need to Know about Borrowing from Your 401(k) to Start a Business
Essentially, when you borrow from your 401(k) to start a business, you are acting as your own bank.
The IRS has regulations that allow individuals to borrow a maximum loan amount at $10,000 or 50% of the vested balance (whichever is greater).
This sounds great – in theory.
Before you get ahead of yourself, it is important to know that not all 401(k) plans allow for investors to borrow from their 401(k)s.
For those that do, there are rules you must follow according to the IRS:
- You can borrow up to what your 401(k) plan allows.
- While there are a few exceptions, you must pay back 401(k) loans within 5 years.
- 401(k) loans are paid back with interest.
In addition, some 401(k) plans do not allow you to make additional contributions until the loan is paid off.
Should I Borrow from My 401(k) to Start a Business?
Let’s get back to the question: Should I borrow from my 401(k) to start a business?
The quick and easy answer is NO.
In short, borrowing from your 401(k) to take a chance on a new business is incredibly risky.
Not only do you have to worry about the business being a success, but you also have to worry about how it will affect your retirement future. And you might be creating a problem for your retirement down the road.
Depending on your 401(k) plan, once you take a 401(k) loan, you can no longer deposit new salary deferrals into the account during the payback period.
Imagine not being able to make contributions to the 401(k) for 5 years and losing the earnings on that money over your working life.
That could be detrimental to your retirement.
There are also other considerations, such as your job.
In order to not face penalties on the 401(k) loan, you must continue to work at the company that sponsors your 401(k).
This means you will have to continue at your current job while also trying to start a business.
With the tax implication and possible financial penalties, it can get costly, very quickly.
Consider the Tax Implications
Let’s talk about the tax implications of borrowing from your 401(k) to start a business.
When you borrow from your 401(k), you’re borrowing pre-tax money.
However, when you start paying back the loan to the 401(k), you pay back with after-tax money.
That’s not all.
The money is then taxed again when it comes out of your 401(k).
Basically, when you borrow from your 401(k) to start a business or for another purpose, you will be taxed twice.
Be Aware of Potential Penalties
As mentioned earlier, there are also potential penalties to consider.
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.”⁴
Let’s say you can’t handle working and running a new business, so you quit. You’ll have to pay back the loan much sooner.
The same rule applies if you change jobs or get laid off.
Under the Tax Cuts and Jobs Act (TCJA) passed in 2017, 401(k) loan borrowers have until the due date of their tax return for the year of distribution to pay it back.
In the event you cannot repay the total loan balance in the mandated time frame, the loan will be treated as an early withdrawal.
If this happens, in addition to having to pay the 10% early withdrawal penalty if you are under age 59½, you’ll also owe income taxes on the full balance of the loan.
Think about the Long-Term Costs
If your 401(k) plan does not allow you to make additional contributions until you pay off your business loan, you’ll miss out on compounded earnings, such as company matching.
For example, if your employer offers company matching, you’ll miss out on those additional funds as well.
Let’s say your 401(k) plan does allow you to continue to make contributions. It won’t be easy.
Many borrowers find it challenging to pay back their loans and make contributions at the same time.
If it takes you the full five years to pay back the 401(k) loan, you may miss out on a lot of money that you need and want for retirement.
Rather than borrowing against your financial future, let your 401(k) do what it is designed to do: grow and support you during retirement.
Instead of borrowing from your 401(k), look for alternatives.
Look for Alternative Ways to Fund a New Business
Should I borrow from my 401(k) to start a business? Not until you have considered every other alternative.
- Do your homework. Before you jump into entrepreneurship, you must do some research. Elizabeth Isele, the founder and chief executive of the Global Institute for Experienced Entrepreneurship suggests, “If you put your idea out there on Kickstarter and no one is willing to invest even a dollar, you know before you put in a huge amount of time that it might not work.”⁵
- Use your network. Don’t be afraid to ask around. Utilize your networks (social media and LinkedIn) to find out what other business owners did to raise capital or get funding.
- Reach out to your local bank. If you have a solid business plan, set up a meeting at your local bank. Banks are more willing to offer loans to individuals who have done their homework and have a clear business plan.
- Look into the Small Business Administration funding programs. There are several different types of funding programs available to small business owners. Visit the Small Business Administration website to see what options best meet your business needs.
Ultimately, it is wise to weigh all the pros and cons (and costs) of borrowing from your 401(k) to fund a new business.
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Sources:
- https://www.nytimes.com/2021/11/13/business/401k-starting-a-business.html
- https://www.nytimes.com/2021/11/13/business/401k-starting-a-business.html
- https://www.forbes.com/sites/forbesfinancecouncil/2020/03/11/how-you-can-use-retirement-funds-to-start-a-business/?sh=557e401c4c93
- https://www.uschamber.com/co/run/business-financing/using-401k-to-start-a-business
- https://www.nytimes.com/2021/11/13/business/401k-starting-a-business.html
