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A Guide to 401(k) Loans

Thinking about starting your own business, but don’t have the capital to get started?  If you’ve been a diligent employee to other companies for years and would like to get started as your own boss, you’ll need a cash infusion – and the best kind of cash is yours.  After all, the money in the 401(k) account is yours, and it may be just the kind of rainy day fund you need to get started with your dream.  Let’s consider how they work and what you should watch out for if you’re considering getting a 401(k) loan.

How They Work

Some employers have stricter rules than others about how and at what cost they’ll allow you to arrange for a 401(k) loan.  You’ll want to discuss the ins and outs with your company account or manager if at all possible – and make sure you get the relevant details of your plan.

Basically, a loan is arranged with your company based on the principal accrued in your 401(k) balance at an interest rate that’s determined by your employer’s benefits package. However, the terms of their plan must be in accordance with section 72(p) of the Internal Revenue Code.  Among other stipulations, the code requires that the loan be over a period of no more than five years (unless it’s a loan to buy a home), that the interest rate be reasonable, and that the employee make regular equalized payments. 

The interest rates and repayment schedule are usually tied in to your 401(k) account balance directly, with all loans, payments, and penalties affecting the tax-exempt income.

Benefits

Acquiring a loan based on money you theoretically already have is a much sounder financial decision than many others employed to garner start-up capital.  Ultimately, you can’t do much worse than lose the money you already have.  If you’re in the frame of mind to start a business and are looking for a cash infusion, a loan like this may seem like a tidy way of advancing your venture.

Pitfalls

Some employers do what they can to exploit the rules of the tax code, for example by declaring the loan in default if a single payment isn’t made on time.  At that point the employer can maneuver to impose the tax penalties associated to a withdrawal.  Make sure you’re familiar with the terms of repayment, and comfortable with what they’ll impose on your financial life.

Although it’s money that’s fundamentally yours, a 401(k) really is designed to serve as an ever-growing nest egg for your retirement.  If you have to deal with illness or other crises down the line, it’s something you know you can depend on.  The decision to get a loan based on that principal has to be weighed against the advantages you’ll enjoy down the line.

Conclusion

Borrowing your own money isn’t the worst way to start a business – but it’s not ideal.  You’re costing yourself a lot of security, and accruing debt that may eventually dwindle your rainy day fund down to nothing.  When considering a choice like this, make sure you know what you’re risking, and make sure you believe it to be worth it.