May 16, 2018

4 Reasons You Shouldn’t Use Your 401k to Start a Business

Sometimes, financing your business with your 401k may seem like a logical choice. However, there are many situations in which the risks of doing this aren’t worth the benefits. Although using your 401k to finance your new business may be a tempting option, there are simply too many reasons why this doesn’t make financial sense. In this post, we’ll explain why you should pursue other options when starting a business.

Why You Shouldn't Use Your 401k to Start a Small Business

1. Early Withdrawal Fees

Withdrawing from your 401k before you reach the age of 59 ½ will almost always result in a penalty of 10 percent of the funds withdrawn. Considering that maximum interest rates on SBA loans are only 7 percent to 9.50 percent, applying for an SBA loan and paying it back quickly makes more sense than diminishing your retirement savings. In addition, it’s important to note that paying these early withdrawal fees defeats the purpose of putting money in your 401k to begin with. Although the money already invested in your 401k can certainly be recognized as a sunk cost, it’s important to recognize why you made the decision to invest in the first place.

2. Risking Your Future Retirement

Your 401k is likely one of the only portions of your financial portfolio that’s meant to be used once you’ve retired. Although starting a business can be a worthwhile investment, it also comes with considerable risk. In fact, nearly half of all businesses fail within their first five years. Due to this, it’s important to remember that starting a business could lead to financial failure. If you withdraw from your 401k to start a business, you’ll have less money set aside for your retirement and it could limit your future growth. Even if your business is ultimately successful, by the time you’re able to return your 401k to its original level, you’ll have willingly foregone a significant amount of compound interest. Depending on your age and the amount you’ve already saved, withdrawing from your 401k can potentially cost you millions of dollars in your much-needed retirement savings.

3. Forfeiting Tax Advantages

One of the reasons that a 401k is among the most popular retirement savings vehicles in the United States is that there are numerous tax benefits associated with them. For example, by allocating some of your earnings into a 401k account, you could avoid having these earnings be taxed as ordinary income. By choosing to withdraw early, however, you will be subject to a new round of taxes in addition to the 10 percent fee you’ll almost always be required to pay. This new round of legal obligations is probably the last thing you would want to take on as a new business owner. You will also likely be disqualified from receiving any of the “Saver’s Credits” that are currently being offered by the IRS.

4. There Are Other Alternatives to Consider

Fortunately, if you’re looking to start a new business, there are other financing options that you can choose from. One of the most common options is a small business loan, but you could also apply for SBA loans, cash advances, or a line of credit, just to name a few examples. Instead of using your 401k, try to pursue one of these options instead, so that you can have business financing while also protecting your retirement fund.

Conclusion: Be Careful With Your Personal Finances

When starting a new business, you may be very desperate for funds, but withdrawing from a secure savings fund such as a 401k to start a business is almost never a financially justifiable solution. If you consider the other options you may have available, you’ll likely find yourself in a much financially secure position.