Should you borrow from your retirement account to keep your business afloat?

If you're a small business owner in need of money to keep your business afloat, you might pursue cash infusions from bank loans, investors, or grants. You may be tempted to borrow from your retirement account as well. But with various rules, fees, penalties, and the potential loss of growth, is this a good idea?

Before you decide to borrow from a retirement account to fund your business, consider these factors.

How do people borrow from their retirement fuunds?

Generally speaking, your eligibility to borrow from your retirement funds depends on several qualifiers: your present employment, the value of your 401(k), and your current age.

Previously, you were allowed to withdraw the lesser of either $50,000 or 50% of your vested balance from either your 401(k) or IRA, but the pandemic brought about some changes to those regulations.

"During COVID-19, the government increased borrowing limits to allow qualifying individuals to withdraw up to $100,000 from their retirement balance," according to Nishank Khanna, co-founder and chief marketing officer of Clarify Capital.

Another advantage of borrowing from your retirement over another loan arrangement is that you are borrowing from yourself. While you are required to pay interest on the money borrowed, that interest is added to your own retirement account.

Ian Wright, CEO of Bequests, a retirement and end-of-life planning information portal, says he has received several queries about tapping into retirement savings during the pandemic.

"Generally, it makes sense to borrow from a retirement plan because the borrowing and payment processes are easy," he says. "It doesn't need a credit check." He warns, however, that you will miss out on some growth if your balance is lower. "What you give up is the growth of your money through compounding interest," he says.

Steps to take before borrowing from your retirement

Before you borrow from your retirement to keep your business afloat, consider other ways to borrow money that won't carry the risks and penalties of retirement account loans.

Stacy Caprio of Deals Scoop, an online couponing site, recommends getting creative. "Look at the value of the assets you own," she says. "Often, you can take out a mortgage on the building you own or a similar play on any high-value equipment you own. This will have fewer penalties and still be able to help inject cash into your business."

Many people turn to retirement borrowing to avoid the credit check and assets disclosure, but this may be a financial misstep, according to Anthony Babbitt, an executive mentor at Babbitt Consulting. He suggests that being subject to the added scrutiny is financially beneficial in the long run.

"Retirement accounts can be used as collateral for a loan, and this is what I advise," Babbitt says. "This has the added benefit of giving you a third party to review your plans. Having to explain your goals and plans to a financier will help you stick to your plan while also exposing any shortcomings in your idea. If the financier won't give you very good terms, that suggests they don't believe you have much chance of succeeding."

Make a repayment plan

If you decide to borrow from your retirement, have a plan for a quick repayment and view the loan as a short-term bridge until a reliable income stream arrives. Babbit says he would only recommend that clients borrow from their retirement in such circumstances.

"For instance, if summer is the busy season for your business and you find yourself struggling to pay bills in March, pulling from the retirement account may allow you to survive until business picks up in May," he says. "Similarly, some startups have inconsistent income streams during the first years. Borrowing from a retirement account may help bridge the time between delivery and payment."

Being realistic about borrowing from your retirement is essential. While you may be emotionally invested in your business—and rightly so as you've put so much work into it—you don't want to hurt your future because you couldn't be realistic.

Corey Vandenberg, a mortgage broker in Lafayette, Ind., who previously worked as a banker, has seen both sides of this dilemma. He recalls the cautionary tale of a borrower who didn't know when to let go.

"I saw a restaurant owner buy a business using his 401k," Vandenberg says. "He then regularly used that money (through further withdrawals) to supplement the business. Eventually, it cost him his entire 401(k) that he had spent 20 years building up. Now the business is long closed, and he has to work past the retirement age of 65 to rebuild what he lost and still has not attained what he could have had."

Vandenberg recommends trying to see your business from an outside perspective. "Take yourself out of it and look at it from an investor side—when will this business pay me back with interest?"

Borrowing from your retirement is not widely recommended and should only be done if the business can pay the loan back quickly. Always be objective and realistic about your business' ability to bounce back, and if need be, seek outside advisers to help you decide what is best for you and for your business moving forward.