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Borrowing From Your 401K to Start a Business

written by: •edited by: Michele McDonough•updated: 7/8/2010

This article looks at how you can borrow from your 401K to start a business. The pros and cons of doing so are discussed.

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    Why Consider Borrowing Against the 401K?

    picture Your 401K is meant to be saved for you to retire on, so why would you consider borrowing against it to fund your business? One reason might be that you feel it is better to borrow from yourself than it would be to borrow from a bank. Another reason you might do it is because it is the only potential source for business funding available to you. Before you borrow against your retirement savings, it is important to evaluate the pros and cons of borrowing against your 401K plan.

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    Good News First - The Pros

    Let's start with the good news first. There are many pros of borrowing against your 401K plan in order to fund your business. The biggest benefit of borrowing against your retirement funds is that you can be debt free with regards to your business startup. In fact, the IRS allows you to borrow from your 401K without having to pay taxes or a penalty on the amount borrowed - so long as you are able to repay the loan within five years.

    Second, by using your retirement funds this way, you are investing the money in yourself. This can cause you to work harder towards meeting your business goals. You can also avoid dipping into your home equity by using your 401K plan to fund your business. You can use the BORSA Plan in order to take money from your 401K and invest in your business. Instead of having to pay money back, the money has been invested, there is no debt (the money doesn't have to be paid back). The idea is that there isn't just one way to use your 401K to fund your business, and you can do so with relative ease.

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    The Cons

    While there are many benefits to using your 401K to fund your business, there are also many cons that can cause you to consider other funding options. The greatest of all the bad news concerns your business itself. If for some reason your business is not profitable (half of all businesses fail in the first year), you will still have to pay back your 401K in order to avoid paying some serious tax penalties. In order to avoid this, make sure that you have a profitable idea.

    Second, if you borrow against your 401K, you will slow the growth of your wealth - and potentially hinder your ability to retire on time. Third, when you pay back your 401K, the payments you make are not sheltered from taxes like your initial deposits were. Finally, it can create a habit where you dip into your retirement account every time you need extra money.

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    The Verdict

    While there are some advantages to borrowing against your 401K to start a business, it is ill-advised. Venture capitalist investments, SBA Loans, and government grants should be your starting point should you need to raise funds to start your business. Why? Because the risks of borrowing against tax-free investments is too great. Take a more conservative approach towards your future. If you must, then only borrow what you must, and pay it back as fast as you can by making extra payments. Don't risk your future unless you know you will make a profit from your business. Finally, resolve not to borrow from your 401K again. It is not an emergency fund, it is to keep you housed and fed in your old age.