When you’re saving for retirement, time matters. The longer your 401(k) funds remain in your account and invested, the more you benefit from compounding — i.e., earning gains on your investment gains.
Of course, investing in a 401(k) isn’t the only way to build wealth. Starting and growing a business can increase your income potential and your net worth, but it can also demand an influx of startup capital.
When you’re looking at a sizable 401(k) balance on the one hand and your need for capital on the other, it may be tempting to take a 401(k) loan to cover business expenses. But is it the right move? Here’s what you need to know.
401(k) loan basics
With a 401(k) loan, you borrow money from your retirement account and pay the loan back, plus interest, within a specific time frame. One advantage to this option is you usually have five years to pay it back.
A 401(k) loan differs from a 401(k) withdrawal because you don’t have to pay taxes or penalties on a loan like you would on an early plan withdrawal. Plus, the interest you pay on the loan goes into your own account rather than to a bank or another lender.
But 401(k) loans aren’t always an option. Not every 401(k) plan allows participants to borrow from their account balance. And even amongst plans that offer loans, there’s a limit to how much you can borrow.
According to IRS rules, the maximum amount you can borrow is 50% of your vested account balance or $50,000, whichever is less. However, plans are allowed to make an exception if 50% of your vested balance is less than $10,000. In that case, your employer can (but doesn’t have to) let you borrow up to $10,000.
And borrowing from your 401(k) isn’t risk-free. If you quit your job or get laid off while you have a loan outstanding, you typically have just 90 days to pay it back. If you can’t pay it off within that time frame, the remaining balance will be treated as a withdrawal, subject to regular income tax as well as a 10% early withdrawal penalty if you’re under the age of 59 ½. While there are a handful of exceptions to the early withdrawal penalty, you generally can’t avoid paying taxes on the distribution.
Things to consider before using a 401(k) loan to cover business expenses
If you’re thinking about taking out a 401(k) loan to start or grow your business, talk to the plan administrator to confirm whether the plan allows loans and how much you can potentially borrow. Then consider the following questions.
How will you repay the loan if the business isn’t successful?
According to the Small Business Administration (SBA) data, roughly one-third of new businesses fail within two years, and half fail within five years.
If the business isn’t a success, will you still be able to afford to repay the loan?
How much investment growth will you miss out on while the loan is outstanding?
When you take money out of your 401(k), you lose out on the potential returns that you would have earned while your money was invested. While you do pay yourself interest on the loan balance, it’s likely less than you would have earned had you left the money invested in the plan.
In addition to missing out on compound earnings, you may not be able to make additional contributions to your account. Some plans don’t allow participants to make contributions while they have a loan outstanding, which could further hinder your progress toward saving for retirement.
Can you afford a decrease in your take-home pay?
IRS rules require that you repay a 401(k) loan within five years, and make payments toward the principal and interest at least quarterly. These loan payments come out of your paycheck, so they reduce your take-home pay.
If you’re struggling to save money to start or grow your business, reducing your take-home pay could make it tough to pay your bills.
Alternatives to a 401(k) loan for business expenses
If you ask yourself the questions above and aren’t happy with the answers, you might want to look into other options for starting or growing your business.
Some alternatives to a 401(k) loan include:
Rollovers as Business Startups (ROBS)
Rollovers as Business Startups, or ROBS, is an alternative form of business financing with your 401(k). Rather than taking money out of your plan or borrowing from it, you use your retirement funds to purchase stock in the company. You can then use the proceeds from the sale of stock to fund the business operations without paying taxes or early withdrawal penalties.
ROBS have been around for decades, but they aren’t for everyone. To establish a ROBS, you have to form a C-corporation and establish a retirement plan for the C-corporation. You also have to work with a ROBS provider and pay a hefty fee to set it up and maintain it. For that reason, it’s usually only a viable option for people with a large amount of money saved for retirement.
ROBS also face a lot of scrutiny from the IRS since they’re prone to abuse. If you go this route, make sure you work with an experienced and reputable provider.
SBA loans can be used to help with the startup costs and ongoing needs of operating a business. Depending on the loan program you choose, you can borrow up to $5 million and the SBA caps interest rates to help keep them affordable for small business owners.
A traditional loan from a bank or credit union may be an option. However, traditional lenders usually have strict lending standards. For example, they may require you to have been in business for at least two years and have excellent credit. They may require you to personally guarantee the loan.
Despite these caveats, it’s a good idea to consider your options there, since shopping around and comparing loan rates and terms can help you find the best financing option available to you.
Ultimately, deciding to tap your 401(k) to start or grow your business comes down to your personal risk tolerance. If you are confident in your business’s prospects, then using your retirement funds might be worth it. Just make sure you weigh the pros and cons and make a plan to pay back the loan within the allowable time frame.