Borrowing from a 401(k) may cost you more than you think

— -- Money Watch, a personal finance column that runs every Saturday, features a financial planner from the National Association of Personal Financial Advisorsanswering reader questions about saving, protecting and growing your money. To submit a question, e-mail USA TODAY personal finance reporter Christine Dugas at: cdugas@usatoday.com.

Q: Why is it often considered a bad idea to use your 401(k) savings to start a small business? My new business is on track, and I am paying back a $50,000 401(k) loan with 5% interest, which is a higher return than most of my 401(k) investments.

A: On the surface it seems like you could be better off borrowing from your 401(k) if the interest rate you are paying yourself is greater than the growth rate in your plan. In reality it is often not true.

When you take a loan out from your 401(k) the entire loan balance is no longer available to grow. For example, if you took a $10,000 loan and paid it back over five years, you would lose out on the growth of $10,000 in the first year. And you would only get the interest on the $2,000 you paid back in the first year. In the second year you would lose out on the growth of $8,000 and only get interest on the $2,000 you paid back, etc.

In this example assume that you take a five-year loan from your 401(k) plan for $10,000 and you pay yourself 5% interest compared with 4% that you earn on your 401(k) investments.

At the end of five years you would have $979 less in your plan, even though the interest rate you were paying yourself was higher than the return on your 401(k) plan balance. And you would lose much more if the growth in your 401(k) plan exceeded the interest rate you were paying yourself.

There are a few reasons why it is risky to borrow from a 401(k) plan to start a new business.

Though you may repay the money you withdraw, you lose the compounded interest you would have received had the money just sat in your account. And some companies restrict you from continuing to contribute to your 401(k) while you're paying back a loan, which could force you to miss out on even more money and the company matching contribution.

If you leave your job, any outstanding 401(k) loan amount becomes immediately due. And if you cannot pay it back in 60 days it is considered a taxable distribution. You will have to pay ordinary income tax on the distribution plus a 10% penalty tax if you are not 59½.

By borrowing from your 401(k) plan you are reducing the amount that is protected from potential creditors should your business fail and you have to declare bankruptcy. But if you can borrow from outside of your 401(k) plan to fund your business and the business fails, the assets in your 401(k) plan are protected from creditors.

Despite all of those caveats, it still may be your best bet, but just make sure you understand the risks.

Christopher Long, NAPFA-Registered Financial Adviser

Long & Associates, Chicago

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