Solo 401(k) Plan Rules

Under a solo 401(k) Plan, a plan participant may be eligible to obtain a loan from the vested balance of the solo 401(k) plan balance without triggering a distribution subject to tax or penalty. With IRA Financial Group’s solo 401(k) plan, the IRA or 401(k) plan funds rolled into the new solo 401(k) plan, as well as any employee deferrals would be vested immediately. In general, diverting plan assets for personal use before a valid distribution usually triggers a prohibited transaction, however, the plan loan feature represents the only limited exception to the prohibited transaction rules (Internal Revenue Code Section 4975(d)(1) and ERISA Section 408).

Solo 401(k) Plan Loan Requirements

In order to be eligible to take a loan from a solo 401(k) plan, the solo 401(k) plan documents must specifically provide for a loan program. The requirements for plan loans are quite technical and out are outlined in Department of Labor (DOL) Regulation 2550.408b-1. IRA Financial Group offers a solo 401(k) qualified retirement plan loan kit that confirms to the DOL loan regulations and include documents necessary to administer a solo 401(k) loan program.

To be exempt from the prohibited transaction rules, a solo 401(k) loan must:

The DOL loan regulations require that the 401(k) plan contain specific provisions regarding loans and the following information must generally be made available to participants in written form:

IRS Plan Loan Requirements

To avoid having a plan loan treated as a taxable distribution to the recipient, the following conditions must be satisfied (IRC Sec. 72(p)(2)).

Repayment Terms

Under IRC Sec. 72(p)(2)(C), the loan amortization schedule must provide for substantially equal payments to be made at least quarterly. Treas. Reg. 1.72(p)-1, Q&A 10, provides for a cure period that allows a loan participant to avoid an immediate deemed distribution following a missed payment. The cure period may not extend beyond the last day of the calendar quarter in which the required payment was due.

Recipients generally must repay loans in full within five years from the date of loan origination (IRC Sec. 72(p)(2)(B)). An exception to the five-year payback rule exists for loans used to purchase a principal residence of the participant. If a participant wants a repayment period longer than five years, employers should obtain a sworn statement from the participant certifying that the loan is to be used to purchase the participant’s principal place of residence (for plan loan purposes, “principal residence” has the same meaning as the term under IRC Sec. 121).

Maximum Loan Amount

Generally, the maximum amount that an employee may borrow at any time is one-half the present value of his vested account balance, not to exceed $50,000. The maximum amount, however, is calculated differently if an individual has more than one outstanding loan from the plan. If the principal loan amount exceeds this standard, the loan amount that exceeds the limit will be deemed a distribution and thus taxable to the participant. In addition, if a loan is treated as a taxable distribution, it is subject to a 10 percent early distribution penalty tax if the employee is under age 59 ½ (IRC Sec. 72(t)). If a plan loan fails to satisfy the loan regulations and is considered a deemed distribution, the employer must use code L to report the distribution on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

EXAMPLE: Bob wants to take a loan from his solo 401(k) plan, which allows for loans of 50% of a participant’s vested account balance up to $50,000. Because Bob has a vested balance of $40,000, the maximum amount that he can borrow from the account is $20,000.

50% x $40,000 = $20,000

If Bob has a vested balance greater than $100,000, he could only borrow $50,000.

NOTE: Plan permitting, a loan, not to exceed $10,000, that exceeds 50 percent of a participant’s vested balance can be made if the amount exceed the 50 percent is secured with additional collateral (IRC Sec. 72(p)(2)(A)(ii)). (Most plans do not provide this option because of the complexity associated with obtaining the additional collateral.)

Loan Limits For More Than One Outstanding Loan

A solo 401(k) plan permitting participants to use the loan feature may have more than one outstanding loan from the plan at a time. IRC Sec. 72(p)(2) provides a specific method to determine the maximum loan amount for participants who have outstanding loans. As described earlier, any new loan, when added to the participant’s outstanding loan balance from the plan, cannot exceed a) the lesser of 50 percent of the participant’s vested account balance, or b) the $50,000 maximum limit reduced by the difference between:

EXAMPLE: The loan program under ABC Inc’s solo 401(k) Plan provides for maximum loans based on the statutory maximum loan amount provided in IRC Sec. 72(p)(2). On January 1, 2013, Jane had a vested account balance in her Solo 401(k) Plan of $125,000 and took a plan loan of $40,000 to be paid in 20 quarterly installments of $2,491. On January 1, 2016, when her outstanding loan balance is $33,322 and her account balance is $140,000, Jane requests another plan loan.

The difference between the highest outstanding loan balance for the preceding one-year period ($40,000) and the outstanding loan balance on the day the new loan is to be made ($33,322) is $6,678. Jane’s new loan plus her current outstanding loan balance (her maximum outstanding loan limit) cannot exceed a) the lesser of 50% of her vested account balance, or b) $50,000 reduced by this difference. The maximum amount Jane can take for her second loan, therefore, is $10,000.

Step 1: Highest outstanding balance - current outstanding balance = the difference

Step 2: The lesser of a) or b) = maximum outstanding loan amount

Step 3: Maximum outstanding loan amount – current outstanding balance = maximum second loan amount

$43,322 - $33,322 = $10,000

Proper Loan Documentation

Plan loan documents should contain sufficient information to clearly demonstrate that the loan program is intended to satisfy DOL and IRS regulations.

Loan Agreement

The loan program for a plan must be evidenced by a legally enforceable agreement (Treas. Reg. 1.72(p)-1, Q&A 3(b)). The loan documents should explain how the loan program operates, including plan loan requirements and the application process. According to regulations, the loan agreement must clearly identify an amount borrowed, a loan term, and a repayment schedule.

Loan Disclosure

For plans subject to Title I of ERISA, a loan disclosure is required as part of the loan program documentation and becomes part of the plan’s summary plan description (SPD). The loan disclosure describes in plain language the loan program terms and provides the name, address, and phone number of the loan program administrator.

Truth-in-Lending Requirements

Some plans may be subject to the Federal Reserve Board Regulation Z (Truth-in-Lending) rules. If more than 25 loans been taken from a plan in the preceding year or in the current year, or if more than five loans that are secured by dwellings have been taken in the preceding year or current year, the truth-in-lending rules apply and an additional truth-in-lending disclosure is required. The Board of Governors of the Federal Reserve has amended Regulation Z to exempt retirement plan loans from the truth-in-lending requirements, effective July 1, 2010, if the plan loan complies with the IRS requirements and is issued from vested portions of a participant’s account.

Spousal Waivers

Under the Retirement Equity Act of 1984 (REA), many plans require that a participant receive the consent of her spouse before taking distributions in a form other than a qualified join and survivor annuity (QJSA). Under these plans, a participant must obtain spousal consent before using any portion of her vested account balance as security for a plan loan (Treas. Reg. 1.401(a)-20, Q&A 24). If a previous plan loan is renegotiated, extended, renewed, or otherwise revised, it will be treated as a new loan, thereby requiring spousal consent.

Other Suggested Forms

To facilitate smooth operation of the loan program, the following forms are useful.

The tax professionals at the IRA Financial Group will assist you in completing all required solo 401(k) plan loan documents.

Defaults and Deemed Distributions

If a loan fails to satisfy the statutory requirements regarding the loan amount, the loan term, and the repayment schedule, the loan is in default and is considered a deemed distribution. In the case of a loan that exceeds the maximum allowable amount, only the excess amount is treated as a deemed distribution (Treas. Reg. 1.72(p)-1, Q&A 4). If a participant fails to make a quarterly installment payment on the loan, the loan is in default and the remaining loan balance is a deemed distribution. Under the loan regulations, the employer may grant a grace period for making a loan payment (by the end of the quarter following the quarter of the missed payment), thus preventing a loan default.

Relief from loan payments also may be granted to participants who are on leave of absence without pay or receiving a rate of pay that is less than the installment payments. In this case, payments may be suspended for a period not longer than one year. To remain in compliance with IRC Sec. 72(p), however, the loan must be repaid within the original time frame provided by the loan agreement.

A deemed distribution will not be treated as a distribution for purposes of the requirements of IRC Sec.1.411(a)-7(d)(5), relating to the determination of a participant’s account balance if a distribution is made at a time when the participant’s vesting percentage may increase.

With the IRA Financial Group, you will be working directly with specially trained tax professionals to help you take a loan from your solo 401(k) plan as well as administer it yourself without the need to hire a special plan administrator.

To learn more about IRA Financial Group solo 401(k) loan program and the rules surrounding the solo 401(k) loan, please contact a tax professional at 800-472-0646.

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