BIZVOICE: Pitfalls to avoid if you must tap 401(k) for small-business cash

As credit markets tighten, getting access to cash is becoming increasingly difficult for everyone, especially small businesses. There is no talk of a bailout plan for America’s 6 million tax-paying businesses with one to 50 employees. But without access to the cash needed to retool during these extraordinary times, even the strongest entrepreneurs are challenged to survive this bitter economic downturn.

Unlike a number of big companies receiving TARP funds, small-business owners must rely on their own ingenuity to quickly adapt and innovate to succeed. It’s the very reason some owners are considering what has long been regarded as a last resort: tapping their 401(k) as a “penalty-free” loan. Some owners have even started a 401(k) for this very purpose —- to get access to cash during these tough times.

The catch, however, is to not get snake bit in the process. When it comes to borrowing from a 401(k), it’s important to understand the good, the bad and potentially ugly aspects of this type of loan. The following gives you the insight to make the right call for your business situation.

The good

There’s no question about it: 401(k) loans have great terms. You can take a loan for up to 50 percent of your vested 401(k) balance (your contributions, rollovers and any vested matching in your account) up to $50,000. The interest rate of the loan is generally a low rate of prime plus 1 percent. The cost to take the loan is nominal —- typically less than $100 —- and you pay yourself back via your 401(k) account interest and all. In addition, there are not the overly cumbersome credit checks you may experience with other loans since you are borrowing from yourself. Sounds great, doesn’t it? Well there are plenty of gotchas to look out for when taking this step.

The bad

While borrowing from a 401(k) provides an easy and low-cost path to cash now, the impact on your retirement savings can be dramatic. Additionally, the tax advantages you were enjoying by contributing to your 401(k) vanish. Albert Einstein once described compound interest as the “greatest mathematical discovery of all time.” Time is the key to compounding. It’s why 20-year-olds who start by contributing small amounts in a 401(k) are often much better off than those in their 40s that contribute a much greater amount to their account. The time your money is out of your 401(k) from the loan is time it will never have again to work for you and grow through compounding.

This is why it’s so important to exhaust every other means to manage your cash needs such as bank loans, a home equity line, SBA loans, family, venture capital firms, etc. before turning to your 401(k). Your nest egg will have a much greater opportunity to grow if it’s left alone and given the time to mature over the long run in ways that generate the most value.

The ugly

It’s also important to understand that if you don’t make a payment on your 401(k) loan for 90 days the outstanding amount of the loan is treated as a distribution. And this is the hard part: Uncle Sam taxes the outstanding balance at your current tax rate plus an additional 10 percent penalty. And there are several more brutal scenarios that have the same nasty outcome on your pocketbook. If you decide to quit or shut down the business, the outstanding 401(k) loan amount is due quickly —- typically within 30 to 90 days. If you don’t pay it back in this time period, it’s considered a distribution and will be taxed at your current tax rate and hit with the added 10 percent penalty.

If you’re unable to pay off the loan, even coming up with the taxes you owe on the outstanding loan balance won’t be easy on your wallet either. It is a truly ugly outcome that you’ll want to avoid at all costs. Note that you will likely avoid the penalty if you are over 59 1/2 years old, but you will still need to pay taxes on the outstanding loan amount.

A plan to make it through

Having access to a 401(k) loan does offer added peace of mind, convenience and low rates, but the pitfalls that exist truly make it an emergency source of funds. These are extraordinary times and it’s no wonder more businesses are considering them. Do start with your bank and consider other means to cash or drastically lowering your business costs in other ways first. If you do take a 401(k) loan, put a plan together that enables you to pay the loan back as quickly as possible. This will help you meet your immediate business needs while minimizing risk. Better yet, by paying it back fast, you’ll keep that money working for you over time so you can enjoy the long-term dreams you have worked so hard to make come true.

> Stuart Robertson, based in Seattle, is general manager of ShareBuilder Advisors LLC, which runs ShareBuilder 401(k), a subsidiary of ING Direct. He can be reached at stuartr@sharebuilder.com