On Loan

Question: I've been working at my job for almost 10 years and I am thinking about starting a car detailing business on the side. My home equity is pretty tapped out, but I have about $150,000 in my 401(k) retirement plan and would like to use it to start my company. Am I allowed to do this?

Answer: The short answer is yes, but there are some strings attached. As long as you're still working for your employer, you can only withdraw money from your 401(k) plan in the event of death, disability or financial hardship. However, if you want to take out a loan against your 401(k), you can borrow up to $50,000 or 50 percent of the vested balance, whichever is less. Typically, you'll pay interest on the money at a rate of prime or prime plus 1 percent and have five years to repay the interest and principal.

But beware: Unlike a home equity loan, the interest you pay on your 401(k) loan isn't tax deductible, and if you default on your payments, the money you have borrowed will be treated as a distribution and taxed as ordinary income. You'll also incur a 10 percent penalty if you're under age 59 and a half. "That's why I refer to 401(k) plans as the lender of last resort," says CPA David Wasserstrum, partner in charge of executive compensation and employee benefits at Weiser LLP, a New York City-based accounting firm that advises midmarket companies.

What happens if your business goes under? According to Wasserstrum, the money that's still in your retirement plan is safe from creditors, but whatever you've taken out is fair game.

For more financing options, check out Entrepreneur magazine's Financing Your Small Business.

Originally published in the February 2007 issue of Entrepreneur Magazine