For some of you a dreaded financial question may stare you in the mirror at some point in your life. Should you borrow against your 401(k)? While all initial responders in your body say no, there could be a few instances where borrowing against a 401(k) may actually make sense. Here is my smart money moves take on when to make yourself a loan.
In general, it is not a smart financial move to borrow against your 401(k) plan. There are many individuals who are quitting their job and considering starting up a new business. In order to start their new entrepreneurial venture, they will likely exit from their current employer. The additional problem is where will the new entrepreneur find the capital to open up their new business?
Instead of cashing in your old 401(k), one tremendously creative option to potentially fund a new business is to set up your new corporation and create a Solo 401(k) plan. Solo 401(k)’s were generally designed for a business owner of one or a husband and wife team. Since after leaving your employer you will not be able to borrow against your 401(k), rolling over your old employer sponsored plan over to your new company Solo 401(k) will reopen your window to borrow your own cash. Remember, if you borrow against an existing 401(k) and you quit your job or they fire you, ultimately the borrowed 401(k) money will be included as taxable income (if you can’t pay it back), and you may be subject to the additional 10% IRS penalty depending on your age, overall financial situation, etc. This is what makes the financial planning strategy of setting up your new company 401(k) so compelling.
Since banks and financial institutions can be very stingy when it comes to giving out unsecured lines of credit to new business owners, this could be a great opportunity to borrow up to 50% of your 401(k) vested balance or $50,000 (which is the maximum), and get the start-up capital you need to begin funding your small business. I have personally helped several business owners use this exact strategy.
You’ll generally have a generous time frame of about five years for a payback period at a reasonable interest rate, and can always pay yourself back quicker if this business gets profitable very quickly in the early stages of growth. Unfortunately too many people just cash out their retirement plans and do not consider these options.
Borrowing from a 401(k) will generally defeat the entire purpose of letting your money sit in a long term tax deferred compounding vehicle. There are very few circumstances where a 401(k) loan will make sense, but this is one idea to keep on your radar.
Written by: Ted Jenkin
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