Question: I am considering borrowing from my 401(k) to start a small home business on the side to generate extra income. Is this a good idea?
Answer: Before tapping into your 401(k), talk to your human resources department to understand the rules of borrowing from your employer’s plan. Most plans allow you to borrow up to 50 percent of your vested account balance, up to a maximum of $50,000. You will have five years to repay the loan, but you can repay the amount in less time without penalty. Repayment can be arranged as a payroll deduction.
If you change jobs or get laid off, there may be a grace period of 60 to 90 days in which you can repay the loan after leaving your employer. If you do not repay the loan within the grace period, the IRS will consider the outstanding loan to be a distribution and expect payment of ordinary income tax on the amount. Furthermore, if you are younger than 59 ½ and fail to repay the loan, you will be assessed a 10 percent penalty on the amount, on top of ordinary income tax. The same is true of loan amounts that are not repaid within the maximum five years allowed for the loan term.
Another issue with taking out a loan from your 401(k) plan is that the borrowed amount will no longer grow. You will forgo all earnings and tax-deferred growth on the money borrowed from the 401(k) plan as a loan. The loan will be an outstanding liability and will reduce your paycheck, because you are required to repay the loan through payroll deduction.
Bottom line: Exhaust all other options and resources before borrowing from your 401(k).