You are a tech entrepreneur, and you like wine. You like it so much that you have decided to start your own winery. The company that you work for has done well, and your 401(k) balance has grown nicely. You aren’t interested in getting a loan from the bank, and aren’t sure they’d lend to you anyway, so you are thinking about using some of the money in your 401(k) to start your new venture. But you aren’t sure whether you should withdraw the money or do a 401(k) loan. So let’s talk about how a 401(k) loan works.
Check to see if the 401(k) plan allows it: The first thing you should do is check your 401(k) plan documents to see whether a 401(k) loan is even allowed. If you don’t know how to get access to them, just ask your company’s plan administrator or HR person. Some people think that just because their company’s 401(k) allows it, that everyone’s does. That isn’t true. Each plan sponsor (the company) is allowed to determine the rules that govern the 401(k) plan. Not all plans allow for loans. So check to see if yours does.
401(k) loan limits: The next thing you need to do is determine how much money you need. The lesser of 50% of your vested account balance, or $50,000, is the legal limit that a person is able to borrow from their 401(k), so if you need more than that, you’ll need to consider other options.
401(k) loan interest rates: A plan that does allow for 401(k) loans must charge (and collect) a reasonable interest rate. Each plan determines the interest rate that they will charge. Sometimes it is a flat rate (i.e. 4%), and sometimes it is tied to an index like the Prime Rate (i.e. Prime + 1%). The good news is that the interest that you are paying on the loan is essentially coming back to your own 401(k) account. So in a sense you are paying yourself.
401(k) payback schedule: Once the plan administrator approves a 401(k) loan and distributes the money, they are required to collect it back according to a payment schedule (the amortization table.) That is usually done by withholding the payments from your paycheck, although some companies do allow for direct payments. It is usually up to the plan sponsor to decide.
Loan term: The maximum amount of time allowed by law is 5 years for general purpose loans, or 10 years if the funds are being used for the purchase of a primary residence.
Full repayment upon termination: One of the biggest drawbacks to a 401(k) loan is the fact that they usually must be repaid in full if you leave or are terminated. For example, if you borrowed $50,000 from your 401(k), and leave after a year to run your winery full time, you will likely need the roughly $40K balance you still have. This is not always true, but is pretty common. The company usually gives you a short window (i.e. 60 days) to pay back the money before they classify it as a withdraw. If they do, you will likely have a sizable tax bill due the next time you file your taxes. So be careful!
Loss of growth: The other big drawback to borrowing from your 401(k) is the loss of growth opportunity on those assets. In order to generate the cash to lend to you, a portion of your investments in your 401(k) are sold. Therefore, any growth those assets would have realized is missed out. However, that downside is partially offset by the loan interest you are paying yourself.
Avoids taxes and penalty: An upside to borrowing from your 401(k), as opposed to withdrawing the money, is that you avoid paying taxes (and 10% penalty if you are under 59 ½) on the withdrawal.
Loans must be paid: Once started, there is no stopping or pausing the payments. This means that even if you get furloughed or take a leave of absence, you must still make the loan payments. Otherwise, the loan will default, and your entire loan (not just the balance) will become a taxable distribution.
These are some of the factors that you must fully consider when deciding whether to borrow money from your 401(k). Most financial professionals will advise against borrowing from your 401(k), especially for risky endeavors like starting a winery. Generally speaking, make sure you will be able to pay the money back, that your job is relatively secure, and that your financial plan is not put at significant risk as a result. However, there are times when it makes sense and may be the best option. Just make sure you speak with your financial advisor, and are fully aware of all of the strings that come with it.