Brother wonders if he should lend $50,000

It pays for a new entrepreneur to try to raise money outside of family and friends.

Q I have been trying to find a way to increase my Roth IRA funding, as I would feel more comfortable in having more tax-free retirement income.  I have an opportunity to do this while helping my brother who needs some funds to purchase a business. I'd like to take a loan/distribution against my 401(k) of $35,000 and $15,000 from my Roth IRA to invest $50,000 in my brother and the business he's buying.  We'd set up a 15-year repayment schedule at 8 percent, with annual payments of about $5,800.  

I understand the implications of borrowing against my 401(k) and loaning money to family. But this would mean a lot to my brother and his family, and even if I never got the $50,000 back, it couldn't ruin our relationship. Also, my wife is on board with the plan. Please give me your thoughts.

A I don't think you'll be surprised that I'm wary of this loan plan. I've been getting lots of similar questions reflecting frustration with low returns on savings. One seemingly easy solution is to lend to family members or friends to help them get rid of high-interest credit card debt, buy a car or remodel a kitchen. The saver earns a better return and the borrower gets a lower rate loan. It looks like a classic win-win situation. But there's a real risk that the lender will lose a friend if the deal sours.

You've thought this through carefully. (Readers should know that you're a middle-aged, two-income family with a solid balance sheet.) Still, I'd hesitate.

For one thing, I don't like loans from 401(k)s. The big risk there is if you lose your job you have six months to pay the loan back or the money you withdraw will be considered an early distribution. You'll owe a 10 percent penalty plus ordinary income taxes on it.

More important, you're taking money out of a well-diversified investment portfolio and putting it into a single asset -- a high-risk loan. Your brother's character is solid. But the failure rate of small business start-ups is high. That's why it's a high-risk loan.

It pays for a new entrepreneur such as your brother to try to raise money outside of family and friends. That way he'll be testing his business plan in the marketplace with people who will want a return on their investment. Their judgments and insights are valuable. He should visit banks that specialize in small-business loans. He could work with counselors at SCORE (the Service Corps of Retired Executives) and the Small Business Development Centers.

My recommendation is to set up a mental account of money available to backstop your brother if money gets tight during the launch of his business. He might hit a stretch when it's a choice between tapping into the credit card or turning to you for a sum to tide him over. That's what brothers (and sisters) are for.

Chris Farrell is economics editor for "Marketplace Money." Send questions to cfarrell@mpr.org.

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