While borrowing from a 401(k) to finance a business venture may offer a creative source of funding, it's generally not a good idea unless you are guaranteed to hit the jackpot.
“It's just a recipe for disaster,” said Thomas Henske, a partner at Lenox Advisors Inc., noting that such a decision can quickly become expensive and can jeopardize retirement savings. “It should be a last-ditch effort.”
First, in order to borrow from a 401(k), you need to be employed at the company providing the retirement plan, which usually means having two jobs at the same time. Be sure to check your plan's documentation to make sure that loans are permitted.
The maximum amount a potential borrower can withdraw without having it taxed is $50,000, or 50% of the vested account balance, whichever is smaller. The interest rate on the loan usually is in the single digits, while the repayment is typically made in substantially leveled payments over five years. The repayments are generally quarterly.
If your business venture takes off and you decide to leave your full-time job (or you happen to be fired), the loan instantly becomes payable in full. If it's not repaid on time, the loan is then taxable as ordinary income, plus a 10% penalty.
“It's probably going to be a bad long-term decision,” said Michael Goodman, president of Wealthstream Advisors Inc. “You'll get cents on the dollar because of the tax you have to pay.” Additionally, retirement savings won't grow as fast during the term of the loan.
While borrowing from a 401(k) can sometimes be a good idea during periods of financial hardship, it's difficult to justify as a funding model based on the success rate of business. According to Funders and Founders, which connects startups with investors, the success rate for first-time entrepreneurs is only 12%. It goes up only to 30% for veteran entrepreneurs who are backed by
venture capital and have already had success in a previous endeavor.
The move is really more of a 'Hail Mary' for those borrowers comfortable with potentially losing it all.
“I'm skeptical of the average person borrowing from a 401(k) to fund their business,” Mr. Goodman said. “But if you think you're the next Facebook, go for it.”
