Invention as the mother of necessity
A few months ago, I got a call from my friend Ken who lives Clifton Park. Ken called to talk about an invention he has been working on in his spare time (podprops.com) and it was fascinating to hear how a simple idea progressed from just an idea to a product soon headed for production. But the real reason for Ken’s call was this: With production pending, it was time for him to come up with more cash and he wondered if borrowing against his 401K was a good idea.
Before I answer that question, there are a few things I need to cover.
The first is the fact that Ken has been with a major corporation in Albany for 15-plus years. Having used his personal savings up in the first few months of his invention’s development, the majority of his savings now sits in the very employer-held 401k he was considering tapping.
The second is that the IRS does allow you to borrow from your 401K, either up to $50,000 or 50 percent of the account value, whichever is less. While the IRS does not count those funds as income and it waives the 10 percent penalty if you are under age 59-1/2 , it does charge interest, usually the Prime Rate plus 1 percent, but the interest paid goes back to your own account.
Given Ken was only looking to borrow $20,000, well below the $50,000 and 50 percent marks, he thought this all sounded pretty good.
Here’s where I interjected the not-so-happy realities of working with the IRS as a financial partner.
The major downside of borrowing against your 401k is that if you lose or quit your job, the money you borrowed must be paid back within sixty days of your last day of employment. If the money isn’t paid back within sixty days it becomes taxable income and potentially subject to a 10 percent penalty if the borrower is younger than 59-1/2 years of age.
Because like most people who borrow against their 401K, Ken has depleted all other savings resources, the likelihood that he’ll be able to come up with $20,000 within sixty days of losing his job and avoid the subsequent tax bill is a pretty big long-shot.
There’s also the whole matter of missed opportunity costs.
If Ken plucks $20,000 from his 401k today, that money won’t be growing in his account tomorrow or the day after. Plus, the money borrowed must be repaid within five years. In order to cover that expense, many people simply reduce their plan contribution further decreasing their retirement savings.
Then there’s a whole tangle of additional IRS rules and restrictions that further limit what you can and can’t do and at what expense. It’s important that you tease each and every one of those out before seriously considering borrowing from your 401k. In most cases, it should only be used as an absolute last resort.
As it turns out, Ken didn’t need to sort through the regulations to determine the 401k loan route wasn’t for him. Instead he got creative and found funding through the crowd funding website kickstarter.com.
So now, even if Ken’s employer were to suddenly go out of business or outsource his position, he’ll still be on pretty solid ground. While he still has debt, there isn’t a sixty-day clock ticking loudly with the promise of a whopping 10 percent penalty and additional taxes if he misses a deadline.
As far as I can see, Ken’s only real concerns of the moment are:
1) seeing his product through production
2) funding a round of drinks for me for the good advice.
Ken, I’ll be waiting for your call.
Jason MacGregor, principal of Minich MacGregor Wealth Management in Saratoga Springs, is a fee-only adviser who provides investment advice to individual company retirement plan participants.