Retirement accounts qualify for special tax treatment by the IRS. A common retirement account is a 401k, where pretax dollars from you, which are often matched by your employer, are deposited into an account and allowed to grow tax-deferred.
These funds are designed to create income during retirement and are subject to premature distribution penalties if the funds are used before the age of 59.5, except in specific situations.
Borrowing from a 401k should not be taken lightly, but if you truly believe in your business plan and think there is very good chance of a better than the market return from investing in your own private business, then this option might be right for you.
Receiving a loan from your 401k is not a taxable event unless the repayment rules are violated. Generally, you can borrow from your own account up to 50% of the account’s value up to a maximum of $50,000. Since the principal is yours the loan payment and any interest assigned is paid back to your own 401k account. In this way, the transaction is like simply moving money from one pocket to another. As such, the cost of a 401k loan is less than the cost of paying real interest to a bank or other lending institution.
The repayment amortization for a 401k loan cannot exceed 60 months and you can repay the loan early with no pre-payment penalty. However, since a 401k is administered through your employer, if you terminate your employment with them the unpaid balance becomes due in full. Therefore a 401k loan is best suited to fund either a side-hustle business while you remain employed or as a way to fund your early pre-startup needs until you replace the loan principal with equity and go full time.
Other than an origination fee there are no costs when borrowing from your 401k. However, the borrowed funds are no longer available for investments in the plan so your 401k will grow more slowly as there are less funds at work.
Since loan payments are made with after-tax dollars there is a double taxation issue that applies to the interest portion of the repayment, but this is generally fairly small and outweighed by other factors. If you fail to meet the repayment rules the loan can become a taxable event and subject you to premature distribution penalties. You should seek specific advice from your CPA or your 401k custodian before using a 401k loan to fund your business.
Can your business benefit from investments from a short-term loan from your 401k? Could a 401k loan be just the ticket for funding needs?
