There are two ways of looking at higher interest rate for Solo 401(k) investors.  On one hand, you can find generally safe investments, such as bonds, that will generate a rate of return of between 5%-8% without much risk. On the other, higher interest rates mean that borrowing money from the plan becomes more expensive. While this is true, this article will explore why higher interest rates can make borrowing money from your Solo 401(k) a high return-type investment while also providing you with up to $50,000 to use for any purpose, tax- and penalty-free.

Solo 401(k) Loan Legality

Internal Revenue Code Section 72(p) allows a Solo 401(k) plan participant to take a loan from his or her plan so as long as it is permitted pursuant to the business’s plan documents. The loan proceeds can be used for any purpose. In general, to avoid having a 401(k) plan loan treated as a taxable distribution to the recipient, the following conditions must be satisfied (IRC Sec. 72(p)(2)):

• The loan must have level amortization, with payments made at least quarterly.
• The recipient generally must repay the loan within five years, although a fifteen-year period can be used for the purchase of a primary residence.
• The loan must not exceed statutory limits.

The maximum amount that an employee may borrow at any time is one-half the present value of his or her 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. A 401(k) loan is permitted at any time using the accumulated balance as collateral for the loan. For example, if one had a 401(k) plan balance of $60,000, one could borrow up to $30,000 (50% of the balance).  Whereas if the plan balance was $250,000 or $250 million, the maximum loan amount would be capped at $50,000.

This loan has to be repaid over an amortization schedule of five (5) years or less with payment frequency no less than quarterly.  A loan period of 15 or 30 years, traditional mortgage terms, may be used if the funds will be used to purchase a primary residence. The lowest interest rate that can be used is Prime as per the Wall Street Journal, which as of May 22, 2023, is 8.25%. This is the highest loan interest rate in many years; from 2009 through 2022, the average Prime interest rate was 3.25%-4.5%. and generally hovered around the 3.25% mark.

However, if a loan fails to satisfy the statutory requirements regarding the loan amount, term, and repayment schedule, the loan is in default and is considered a deemed distribution. Taxes would be due on the amount not repaid. Further penalties may apply if you are under the age of 59 1/2.

Solo 401(k) Loan Procedures

Most 401(k) plan participants would need to work with the plan administrator or the company’s human resource department to guide you through the loan process. For IRA Financial Solo 401(k) plan clients, taking a Solo 401(k) loan is quick and easy and can be done online or via our app. In the case of a Solo 401(k) plan, the business owner will generally serve as the trustee and plan administrator of the plan. Essentially, the trustee or plan administrator will need to sign off on the loan, which in the case of the self-employed or a small business with no full-time employees, means the business owner can approve their own plan loan.

The primary advantage of using a 401(k) loan feature is that the individual will gain the ability to use up to $50,000 of retirement funds without tax or penalty.  In addition, the loan payments of principal and interest are pad back by the individual to his/her plan account, thus, increasing the overall value of the 401(k) plan assets over the loan period.

The Difference between a Loan and a Distribution

A 401(k) loan is a way to take money out of your plan subject to the loan repayment requirements. A 401(k) plan distribution/withdrawal is subject to the plan triggering event rules meaning you don’t have access to the 401(k) funds while still working for the company that sponsors the plan unless you qualify for a hardship distribution.

All distributions are treated as taxable income, and a penalty will apply to early withdrawals. Plus, once you distribute funds from the plan, they can’t be returned.

Can I Set Up a Solo 401(k) Plan?

To be eligible for a Solo 401(k), you must first have a business. Anyone with self-employed income is considered a business (sole proprietor) even if you don’t have a physical location or employees. That satisfies one of the requirements. The other is that you cannot have any non-owner, non-spouse, full-time employees. To simplify, if you have any full-time employees that are not either an owner, or the spouse of an owner, you are not eligible for a Solo. Full-time is considered 1,000 hours worked in a given year, or 500 hours for three consecutive years. Part-time and ineligible employees are allowed to work for your business and not affect Solo 401(k) eligibility.

Solo 401(k) Loan – Pros and Cons

Advantages of Borrowing from your 401(k) Plan

• Ability to get quick access to cash.
• Use the loan for any purpose tax- and penalty-free.
• Lower interest rate than a credit care or payday loan.
• Interest is being paid back to your plan and not an outside lender.
• Ability to pay a higher interest rate to increase the value of the plan over the long run.

Disadvantages of Taking a Loan

• Failure to pay back the loan will result in a taxable distribution and a 10% early distribution penalty if under the age of 59 1/2.
• Money borrowed from the plan is no longer growing without tax.
• Might need to liquidate assets to have the needed cash to borrow.
• Studies show that many people have a problem paying back 401(k) loans and there is a relatively high delinquent rate.

Guaranteed 8%+ Return on a Plan Investment

As mentioned above, higher interest rates can be a huge opportunity when it comes to maximizing the Solo 401(k) loan strategy.  For example, a $50,000 loan over five years will generate $11,188.75 tax-free back to the plan.  Whereas if the Prime interest rate was just 4.50%, the loan investment would only generate $5,929.06 over five years.

In both cases, the plan participant would gain the use of the plan funds without tax, however, the return on the loan investment would be lower due to the interest rate.  Obviously, the higher interest rate means you would have to make higher plan loan payments, which will likely impact the cash flow of the individual and could even make borrowing out of reach for some. 

For those that have the needed cash flow, you have an opportunity to stuff your401(k) plan with extra tax-free cash.  Because the plan participant is making the loan interest payments and can control the process, the plan is essentially receiving, at a minimum, a guaranteed 8.25% rate of return on the loan transaction.  Based on the 401(k) plan documents, the plan participant can even use a higher interest rate to contribute even more tax-free funds into the plan.

Conclusion

For some 401(k) plan participants, a higher interest rate environment could prove to be a great opportunity to stuff extra tax-free funds into the plan while simultaneously gaining tax-and penalty-free access of up to $50,000, which can be used for any purpose. The higher interest rate means higher loan payments, which could be an issue for some plan participants.  However, for those plan participants that have the personal cash flow to pay the higher loan payments, the ability to contribute extra tax-free funds into the plan as a result of the high interest rate is a big bonus.

Of course, you should consider all factors before deciding on taking out a 401(k) loan. Speak with a professional to see if it makes sense in your situation.