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Solo 401k Loan

Solo 401(k) loan
5 Minute Read

A Solo 401k loan is permitted at any time using the accumulated balance of the Solo 401k as collateral for the loan. A Solo 401k 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 5 years or less with payment frequency no greater than quarterly. 

Solo 401(k) Loan Rules – 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 401k loan program.

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

  • Available to all participants of the Solo 401(k) plan on a reasonably equivalent basis;
  • Made in accordance with specific provisions of the loan program contained in the Solo 401(k) plan
  • A reasonable interest rate, which based on the loan kit, is considered to be at least the “Prime” rate of interest, which as per the Wall Street Journal is 3.50% as of March 28, 2022, and
  • Adequately secured (DOL Reg. 2550.408b-1(a)(1)

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 the:

  • Identity of the person or positions authorized to administer the 401(k) loan program;
  • Procedures to be used in applying for loans;
  • Basis upon which loans will be approved or denied;
  • Procedures used to determine a reasonable interest rate for plan loans.

Related: Can I use a Solo 401(k) Loan to Make an Investment?

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)).

  • The loan must have level amortization, with payments made at least quarterly.
  • The recipient generally must repay the loan within five years.
  • The loan must not exceed statutory limits.

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).

Pros and Cons of a Solo 401k Loan

The Benefits of the Solo 401k Loan:

  • Your 401(k) plan is there to accrue money for when you retire. You earn money based on the investments you make. But, what if there’s an investment you want to make outside of your plan? A loan makes sense, but only if your outside investment will make more money in the long run.
  • On the opposite end of the spectrum is high-interest debt, such as a credit card. A 401(k) loan, with favorable rates, might be a great way to wipe out your credit card debt. Even if you are not paying off debt, the favorable rates of a Solo 401k loan is quite appealing.
  • What if you can’t get a traditional loan at a regular financial institution? You don’t need to qualify for a 401(k) loan. There’s no credit check to borrow your own money! Further, instead of paying the bank interest from a loan, you pay interest back to your 401(k) plan. Essentially, you are building back your 401(k) with payments from the loan (both principle and interest).
  • Get your loan easier and faster! There’s a lot of rigamarole to getting a bank loan. Usually, a 401(k) loan application is much easier to complete and you will receive your funds much faster than another financial institution.

Related: Can I Borrow From an IRA? 

The Risks of a Solo 401k Loan:

The major risk of taking out a 401(k) loan is the earnings that money would’ve accrued if they remained. If you are reinvesting those funds, you better make sure the earnings are greater than they would have earned if they stayed in the plan. For example, if you were earning 10% on average with a $50,000 balance, that’s $5,000 annually. Borrowing $10,000 will reduce those earnings to $4,000. The power of compounding works better the higher the account balance is.

If using a loan to pay off debt or relieve a tough financial situation, it may prove impossible to get ahead and still save for retirement. Unless you have no other options, don’t borrow from your future self. The goal is to get to retirement as soon as possible with enough money to live off of.

If you have a traditional 401(k) and you plan on leaving your job, the loan becomes due in full once your employment is terminated (for whatever reason). New rules give you until October 1 of the following year to repay the loan. However, plans might require it sooner. If you fail to pay off the entire balance, the amount still outstanding will be treated as a distribution. You will pay taxes on that amount and be hit with the early distribution penalty if you are under age 59 1/2.

Lastly, there’s double taxation. Traditional 401(k) plans are funded with pre-tax dollars. You pay taxes only when you withdraw from the account. Therefore, even though you are paying the interest back to yourself, you are doing so with after-tax dollars. When you hit retirement and withdraw from the account, you will need to pay taxes on the interest you paid on the loan.

Related: Investing in Alternative Assets with Retirement Funds

When can a Participant Solo 401k Loan be Useful?

As a result of the recent economic meltdown, banks and other financial institutions have severely limited their lending capacity to self-employed business owners, thus, causing grave financial pressure on self-employed business owners. The Solo 401k plan is a perfect structure for any self-employed business owner seeking immediate funds for their business or to help pay personal expenses. Solo 401k participants can borrow up to either $50,000 or 50% of their account value – whichever is less to help finance or operate their business.

Other useful ways of using the participant Solo 401k loan feature is to:

  • Lend the funds to a third-party who will pay a higher interest rate
  • Invest in a real estate project that offers a higher rate of return than the low interest rate you must pay
  • To consolidate debt
  • To pay for college expenses
  • To pay for unexpected emergencies
  • Avoid distribution penalties and use up to $50,000 immediately with no restrictions
  • Invest in a new franchise or business
  • Make any alternative Investment that will generate a higher rate of return than the low Interest rate imposed on you, such as tax liens, private placements, or mortgage pools
  • Invest in a transaction that would otherwise be a Prohibited Transaction under Internal Revenue Code Section 4975
  • Quick, easy, and cheap access to a $50,000 loan to be used for any purpose

Read More: Solo 401(k) 2022 Contribution Rules

Conclusion

A Solo 401k plan loan is not for everyone. The risks involved may not override the potential benefits. Sometimes, a loan may be your last recourse to settle a debt or remain financially stable. Other times, a loan may be beneficial for another investment, such as starting your own business. Whatever your reason for taking a loan from your Solo 401k plan, it’s best to consult with a financial adviser to see if it’s in your best interests, or if there are other things you can do.

If you have any questions about the Solo 401k loan, please contact us at 800.472.0646 today.

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[10:44 PM] Valerie Marszalek-Boik