Today's guest post is by Frank Armstrong, CLU, CFP®, AIFA® and the president and founder of Miami-based Investor Solutions, an independent, fee-only fiduciary investment management firm. ions.com
It’s always a bad idea to raid your retirement nest egg, but if you’re a business owner looking to finance operations, it may be even worse. Here’s why:
- You have a huge risk in an un-diversifiable entity, your company. Financing operations with your 401(k) account spreads that risk to your retirement plan. If the company fails, your retirement plan will take a big hit and you still must pay back the 401(k) loan, or you will incur penalty tax on a premature distribution.
- Assets inside your qualified plans like a 401(k) are protected against creditors. Only two
“super creditors” the IRS and a domestic court could attach them. Loan proceeds lose that protection. - A 401(k) is not a piggy bank or a revolving line of credit. It’s for your future retirement.
- Loans from your 401(k) pay a very low interest back to the plan, so the opportunity cost to your retirement plan could be very high. A practice of borrowing against the 401(k) will reduce your future retirement plan accumulation.
- Unlike a mortgage on your home, interest paid to the 401(k) isn’t tax deductible.
Sometimes, however, borrowing against the 401(k) may be the least bad choice you have. You may borrow up to 50% of your vested balance up to a maximum of $50,000. That money must be repaid by a schedule against your earnings over 5 years, unless it’s for a first time home loan where the time frame is 30 years. Failure to pay it back on schedule triggers a premature
distribution penalty and ordinary income tax on the remaining balance. Not pretty!
Here’s why you might think it’s the least bad choice:
- You don’t have to pass a credit check. If your plan allows for loans, it’s automatic that you get it.
- Interest rates are very low. Using a 401(k) loan to pay off credit card debt, student debt or other obscenely high interest consumer debt might actually improve your financial situation.
As always, consult with your financial and tax advisors before making important financial decisions.