Impacts of 401(k) Loans on Your Small Business and Retirement

Impacts of 401(k) Loans on Your Small Business and Retirement

Starting or growing a small business is an exciting endeavor, but it also requires a significant amount of capital. Many aspiring entrepreneurs turn to their retirement savings as a source of funding. Specifically, borrowing from a 401(k) account can provide tax-free cash quickly and easily. However, 401(k) loans come with risks and should be approached carefully.

This article will examine the pros and cons of 401(k) business loans, their impact on retirement savings, rules and regulations, and alternatives to consider. We’ll also look at real-world examples to illustrate the key points.

The Allure of 401(k) Loans

It’s easy to understand the appeal of 401(k) loans. Retirement accounts often represent one of the largest pools of personal capital available. Compared to securing a business loan from a bank, 401(k) borrowing can be faster, more convenient, require less paperwork, and avoid debt. With some limitations, you can access up to $50,000 or 50% of your vested balance quickly. Because you’re borrowing from yourself, there are no credit checks or interest rates. 401(k) loans allow you to leverage your own money rather than taking on business debt.

Many entrepreneurs are drawn to the flexibility of 401(k) loans. You can use the funds for any business purpose – whether it’s purchasing inventory, equipment, real estate, or simply providing operating capital. There’s no bank telling you how to run your company. And you can design your own repayment terms up to 5 years. Essentially, if you need capital to start or grow a business, your 401(k) can provide it easily.

An added benefit is that the money you borrow continues working for you. Although it leaves your 401(k), loan payments including principal and interest go back into your account. And you pay yourself the interest rather than paying it to a bank. In effect, a 401(k) loan provides capital while allowing your retirement savings to keep growing.

Downsides of 401(k) Loans

While 401(k) loans offer clear advantages, there are also significant drawbacks to consider:

• Your retirement savings stop growing on the borrowed amount. Although you pay yourself interest on the loan, that money would otherwise be invested and compounding.
• You lose out on market returns. During the loan term, typically 5 years, that money is not participating in any market gains.
• It can be risky taking money out of the market. If stocks drop during your loan term, you’ll have less invested to participate in the recovery.
• It’s easy to overestimate your ability to repay. Financial projections are uncertain and repayment can become difficult.
• Job loss can trigger immediate repayment. You’ll owe taxes and penalties if you default on the loan.
• Your credit score may suffer if you miss payments.
• The remaining balance in your 401(k) has less diversification.
• You lose flexibility if you need to roll over your 401(k) to an IRA.
• The loan balance can count against you in bankruptcy.

The bottom line is 401(k) loans remove money intended for retirement. They prevent assets from being fully invested and compounding. While paid back amounts continue growing, the downsides make borrowing less advantageous than it may seem.

Rules and Regulations

If you do pursue a 401(k) loan, be sure to understand the applicable rules:

• Loans are limited to $50,000 or 50% of your vested balance, whichever is lower.
• Interest rates are set by your plan, often around prime rate plus 1-2%.
• Most plans require regular loan payments through automatic payroll deduction.
• You must repay the loan within 5 years, with some exceptions.
• If you leave your job, the loan must usually be repaid in full immediately.
• Defaulting triggers income tax plus a 10% early withdrawal penalty.
• You can only have one outstanding loan at a time.
• Plans may restrict the number of loans you can take.
• Loan proceeds are not subject to taxes or penalties.

Be sure to consult your plan administrator for your company’s specific 401(k) loan provisions. The rules are intended to keep borrowing limited, structured, and as low risk as possible. However, they also constrain your flexibility and ability to leverage your retirement funds.

Impact on Retirement

Opinions vary widely on whether 401(k) loans are good or bad for your retirement savings. Some key factors include:

• Your age – Loans have less impact on younger savers with more time.
• Market performance during your loan – Volatility can magnify the risks.
• Your loan purpose – Will the benefits outweigh the costs?
• Your ability to repay – Are you being realistic?
• Your other savings – Can you afford to temporarily reduce retirement assets?
• Your post-loan retirement outlook – Will you still be on track?

In general, the younger you are and the more retirement savings you have, the less impact a 401(k) loan will have. But frequent borrowing can still erode your nest egg over time. Be honest about your ability to repay. And be sure the business potential outweighs the retirement trade-offs.

Alternatives to Consider

Rather than tapping your retirement funds, here are some other business financing options to consider:

• Personal Savings – Avoid retirement accounts and use your own savings if possible.
• Friends & Family – Ask for support from those close to you.
• Business Credit Cards – Use cards offering 0% intro APR periods.
• Business Bank Loans – Explore SBA loans which back small business borrowing.
• Business Lines of Credit – Reusable financing that may be easier to obtain.
• Peer-to-Peer Lending – Borrow from a pool of peer investors.
• Crowdfunding – Raise small amounts from a large number of supporters.
• Angel Investors – Get funding from high net worth individuals.
• Venture Capital – Attract investment from VC firms.

Each option has its own pros and cons. But exploring business financing alternatives reduces the need to tap your retirement funds. This can help mitigate the risks and potential downsides of 401(k) borrowing.

Case Study #1 – ROBS Success

Ellen, 56, wanted to open a bakery after retiring early from her corporate job. She had $85,000 in a 401(k) and very little other savings. The cost to lease space, purchase equipment, and fund operations for the bakery’s first year was estimated at $55,000. Ellen opted to use a ROBS (Rollover Business Startup) to fund the venture with her 401(k).

After setting up a new LLC, Ellen rolled over her 401(k) balance into a $55,000 self-directed IRA. The IRA then purchased stock in the LLC, providing it $55,000 in capital to start the bakery. While risky, Ellen successfully opened the bakery without taking on business debt. And she avoided early withdrawal penalties by structuring the capital injection as a ROBS rather than cashing out her 401(k).

Case Study #2 – Loan Default

Steve, 62, left his corporate executive job two years before retirement age to launch a consulting business. To help cover his salary until revenue picked up, he took a $50,000, 5-year loan from his 401(k) which had a $340,000 balance. However, the business struggled and Steve defaulted on the loan after just two years.

The outstanding $32,000 loan balance was deemed an early withdrawal. Along with income tax, Steve paid a $3,200 (10%) early withdrawal penalty. The withdrawal also pushed him into a higher tax bracket for the year. Between taxes and penalty, the $32,000 default ended up costing him $21,000 out of pocket. Steve’s retirement savings dropped by over 10% as a result of the 401(k) loan default.

Key Takeaways

Borrowing from a 401(k) or retirement account to fund a business seems appealing but comes with inherent risks. It reduces assets intended for your future, prevents them from being fully invested, and deprives them of market growth. While paid back amounts continue growing, consider both the pros and cons carefully before moving forward. Explore other financing options first, and have a realistic repayment plan if you do take a 401(k) loan.