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How to Use a Solo 401(k) to Fight Inflation

How to Use a Solo 401(k) to Fight Inflation
3 Minute Read

Higher prices at the gas pump, grocery store, and pretty much everywhere has put a lot of pressure on Americans.  Annual inflation rate in the US was 8.3% in April 2022, off a 41-year high of 8.5% in March. Energy prices increased 30.3%, below 32% in March namely gasoline (43.6% vs 48%) while fuel oil increased more (80.5% vs 70.1%).

On the other hand, food prices jumped 9.4%, the most since April 1981 and prices also rose faster for shelter (5.1% vs 5%) and new vehicles (13.2% vs 12.5%). On a monthly basis, consumer prices were up 0.3%, slightly more than expectations of 0.2% but below a 16-year high of 1.2% in March.  Things may actually get worse.  Most of China continues to be in COVID lock-down which is greatly stressing supply chains.  Plus, the war in Ukraine does not seem to be ending anytime soon.

The costs for food, gas, traveling, and especially home rentals continue to rise, placing a high degree of financial stress on many Americans.  For individuals with access to a 401(k) plan, as well as the self-employed, the 401(k) plan loan feature could become your cash flow crunch solution.

The 401(k) Plan Loan

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.

The loan is permitted at any time using the accumulated balance of the 401(k) as collateral for the loan. One 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 less than quarterly.  The lowest interest rate that can be used is Prime as per the Wall Street Journal, which is 4.0% as of May 20, 2022. 

A 401(k) loan can be used for any purpose.  Best of all, you gain tax- and penalty-free use of the proceeds to use for any purpose.  In addition, interest from the loan, which is paid back to the plan, will generate a decent enough rate of return. Not only do you get the use of your retirement funds in the short-term, you can return more money to the plan for retirement.

What is a Solo 401(k) Plan?

A Solo 401(k) plan is an IRS-approved retirement plan, which is suited for business owners who do not have any employees, other than themselves and perhaps their spouse. It’s also the best savings tool for the self-employed.

Eligibility Requirements

The Solo 401(k) plan may be adopted by an individual sole proprietor, or any other business entity, such as an LLC, corporation, or partnership.  In general, in order to be eligible to benefit from the Solo 401(k) plan, one must meet just two eligibility requirements:

(i) The presence of self-employment activity.

(ii) The absence of full-time employees.

The following types of employees may be generally excluded from coverage:

  • Employees under 21 years of age
  • Spouse of an owner
  • Employees that work less than a 1000 hours annually
  • Union employees
  • Nonresident alien employees

In sum, so long as the activity rises to a trade or business and there are no non-owner, full-time employees, excluding spouses of the owners, you can generally start a Solo 401(k) for yourself or your business.

The Solo 401(k) Loan Option for the Self-Employed

An IRA, including a Roth IRA, does not allow one to borrow even one dollar from the plan. The only way to borrow funds from your retirement plan is with a Solo 401(k). Again, assuming your Solo 401(k) plan documents allow for a loan, you can borrow up to $50,000 or 50% of your account value, whichever is less. The funds can be used however you wish, including paying down debt, capital for your business, or to help weather the inflation storm brewing.

IRA Financial Group’s Solo 401(k) plan documents will allow a self-employed individual to utilize the loan feature. Because you are self-employed and have the freedom to choose your own plan, you can ensure it contains all the features you want. Not all workplace plans will allow you to borrow from the plan.

Important Facts about the Solo 401(k) Loan:

  • You must repay the loan over an amortization period of five years or less (there are no penalties if you pay it off in less than five years)
  • The interest must be set at a reasonable rate – generally interpreted as the Prime interest rate as per Wall Street
  • Payment frequencies can be no less than quarterly

It’s important to note that your Solo 401(k) plan documents must allow for a loan, and the proper loan documents must be prepared and executed. If the loan payments are paid on time, there are absolutely no penalties or taxes applied when you take out a loan. 

Conclusion

The Solo 401(k) plan can prove to be a valuable tool to help the self-employed or small business owner handle rising costs because of inflation.  With the expectation that inflation could keep increasing for the rest of 2022, gaining the ability to borrow up to $50,000 tax-free and use those funds for any purpose could end up being a real financial lifesaver for many Americans.

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[10:44 PM] Valerie Marszalek-Boik