The loan option is one of the key advantages of establishing a Solo 401(k) plan versus a SEP IRA. The ability to borrower the lesser of $50,000 or 50% of your plan account value tax- and penalty-free and use the funds for any purpose is a huge benefit. Plus, the interest on the 401(k) loan is paid back to the plan as a return on investment. The following will teach you everything you know to borrow from a Solo 401(k).
Internal Revenue Code Section 72(p) allows a 401(k) plan participant to take a loan from his or her 401(k), so as long as it is permitted pursuant to the business’s 401(k) Plan documents.
A 401(k) loan is permitted at any time using the accumulated balance of the 401(k) as collateral for the loan. The participant can borrow up to either $50,000 or 50% of their account value – whichever is less.
This loan has to be repaid over an amortization schedule of five years or less, with payment frequency no greater than quarterly. The interest rate must be set at a reasonable rate of interest. The lowest interest rate permitted to be used for the 401(k) loan is the Prime Rate, as per the Wall Street Journal, which, as of 5/20/2022 is 4.00%. If the loan payments are not timely made, the outstanding loan amount would be treated as a taxable distribution subjecting it to tax, plus a 10% early distribution penalty if the plan participant is under the age of 59 1/2.
How does Interest Work on a 401(k) Plan Loan?
A 401(k) plan loan is a straight-line maximum five-year loan. In other words, interest and principal are combined to make up each loan payment. For example, a five-year $10,000 loan would have a monthly interest payment of $184.17 for a total of $1,049 interest paid over the course of the five-year loan.
Most 401(k) loans do not include a prepayment penalty. Not only do you get tax-free and penalty-free use of the funds, the plan earns a 4.00% rate of return on the loan. Moreover, a plan participant can technically elect to use a higher interest rate but must be mindful of the relevant state’s usury rules. Selecting a higher interest rate would allow the plan participant to generate higher returns for the plan. However, a failure to make timely loan payments could trigger a taxable distribution.
401(k) Plan Loan – Pros and Cons
The main advantages of taking a loan from a 401(k) plan is as follows:
- Ability to get quick access to cash
- Low interest rate – Prime Interest Rate is currently 4.00% – much less than a credit card or pay day loan
- Interest is being pad back to your plan – helping increase the value of your plan. For example, a $50,000 loan at a 4.00% interest will generate approximately $5,500 over the course of the loan.
- Ability to pay a higher interest rate on the loan allowing one to increase value of 401(k) plan while gaining the ability to use loan funds for any personal purpose.
The main disadvantages of taking a loan from your 401(k)?
- Failure to pay back to loan will result in a taxable distribution and a 10% early distribution penalty if under the age of 59 1/2
- Money you pull out for loan will no longer grow tax-deferred
Studies show that many people have a problem paying back the loan and there is a relatively high delinquent rate. In the case of a workplace 401(k), when one changes jobs, the loan will become due in full.
What is the Difference Between a 401(k) Loan and a 401(k) Withdrawal?
Obviously, a loan is borrowing the plan funds with an obligation to pay it back. A 401(k) withdrawal, also called a distribution, is when you remove funds with no intention of putting them back in the plan.
It’s important to keep in mind that you generally cannot withdraw funds from a retirement plan at your current employer. You would need a plan triggering event in order to distribute the plan funds. The most common triggering events is separation from the job, reaching the age of 59 1/2 or the plan is terminated. Funds from an old retirement plan can be rolled over at anytime. Essentially, you already had a triggering event by separating from that job.
Assuming the plan documents allow for it, you can take a loan at any time and for any reason. There is no need to satisfy any type of requirements to borrow from your 401(k) – unless, of course, your employer has additional rules in place.
How to Borrow from a 401(k) Plan
The process for borrowing funds from a 401(k) plan generally depends on your employer. For example, if one established a Solo 401(k) plan with IRA Financial, the plan trustee can simply go on our app and complete the loan application. The Solo 401(k) loan application is quite simple and easy to complete. The borrower would just need to provide the following info:
- Name of borrower
- Amount to be borrowed
- Interest rate to be used
- Signature of borrower (signature of borrower’s spouse is only required in a community property state).
Once the loan application is complete, the plan administrator, which is usually the same person as the borrower, in the case of a Solo 401(k) plan, can transfer the funds via check or wire. The borrower must make sure to pay back loan payments in a timely manner. A common technique used by many borrowers is to set up reoccurring ACH transfers, or using post-dated checks.
Many plans have a three-month or longer “cure period” to cure missed loan payments. However, in the case of a 401(k) plan loan in default (after passage of the cure period) the plan participant must either:
- make a lump sum payment for the missed installments (adjusted for interest);
- reamortize the outstanding loan balance, resulting in higher payments going forward; or
- a combination of a make-up payment and reamortization of the loan.
If you are looking to access 401(k) funds for personal or business purposes, the plan loan feature is a good start. You should ask your employer if a plan loan option is available. If you have your own Solo 401(k) plan, then taking out a loan is quick and easy. If you are self-employed or have a small business with no full-time employees, setting up a Solo 401(k) plan for purposes of using the loan feature can also make sense.
The 401(k) plan loan is a tax-efficient way to gain tax-free use of a portion of your 401(k) funds which can be used for any purpose: personal or business.
It can help pay bills or solve a cash flow crunch. In addition, the interest paid on the 401(k) loan is paid back to your plan instead of a bank. While taking money from your retirement plan should be a last resort, borrowing from a Solo 401(k) may help in a bind.