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Instead of taking a loan from a business or a lender, entrepreneurs take out a loan from themselves by unlocking their own retirement funds. After all, they don't have to worry about credit checks, qualifications, and anyone (anyone = credit agencies) knowing about it.
Sounds great, doesn't it? Then why don't more people do it? For one thing, you can't borrow against a traditional IRA. So what you can and can't do with your retirement money depends on its rules. Most only let you borrow up to $50,000.
The situation also depends on your own work situation. Are you still working in a day job while building a new business? Should you leave the day job after taking money out of a retirement account, you could be in for a surprise. You may have to immediately pay back the money you took out or it becomes a withdrawal -- meaning, taxes and penalties and losing more money.
Furthermore, many retirement loans require repayment within five years and the repayment fees could be higher than taking out a different type of loan. What if you can't make your payments? Taxes and a 10% early withdrawal penalty kick in. Missing just one payment could lead to defaulting on the loan and then you can't reinstate the loan.
Your age at the time of withdrawing the money could also factor in with taxes and penalties. If you make all your loan payments -- always a good thing -- the value of the account could drop if the interest rate is lower than the market return on the account. In other words, what you took out and pay back could lead to a drop in your retirement because interest can't make up the difference.
Let's use a very simple example. You borrow $50 from yourself through your retirement fund. You pay it back on time with interest and end up with $60. Had you left the account alone letting it accrue interest at its rate -- it could be $70. Now imagine if these were bigger numbers.
What if your business fails? Not to trying be Mr. Pessimistic here -- more like Mr. Realistic. I'd quote stats, but it looks like few agree on the percentage of businesses failing within the first year or the first five years. The risk, however, may not be worth taking as a failed business also means kissing retirement and financial security good-bye and starting over.
The gloomy outlook on retirement savings as outlined in a Transamerica Retirement Survey indicates that building it back up will be a mountainous climb. "About 18 percent of all workers had retirement account loans outstanding in 2007, compared with 11 percent in 2006," says the survey.
So what can you do? Build a good business credit score and explore safer and less risky venues for a loan. Safer routes:
- Rely on a bank, credit union, or credit card loan.
- Go to a brokerage firm with securities acting as collateral.
- Find a lender with a plan that meets your needs.
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