If you are self-employed and utilize a Solo 401k plan to save for retirement, you can usually borrow from the plan. A Solo 401k loan can be a viable option if you need money fast and you are out of options. Generally, it’s not usually advised to take money out of your retirement plan, however, there are instances when it makes sense. In the following, we will talk about the ins and outs of the Solo 401k loan, along with the pros and cons of taking one.
What is a Solo 401k?
A Solo 401k plan, also called a One-Participant 401(k), Individual 401(k) or Self-Employed 401(k), is a regular 401(k) specifically designed for the self-employed. You can only utilize one if you have either a) self-employment income or b) an owner-only business. One of the major differences that sets a Solo 401k apart from other plan is the contribution limits. For 2019, you can contribute up to $56,000 (or $61,000 if you are age 50 or older). Further, if you have “checkbook control” of your Solo 401k funds, you can invest in anything not impermissible by the IRS. This includes real estate, precious metals and tax liens. It’s arguably the best retirement plan option for the self-employed.
Taking Out a Solo 401k Loan
Assuming your plan provider allows it, a Solo 401k loan may be taken for any reason. You never have to relate your intent for the funds to anyone associated with the plan. What you do with your money is your business. Taking a loan is as simple as requesting one and filling out a loan agreement. The plan administrator must set a “commercially reasonable interest rate.” Usually, the interest is based on the current Prime Rate, which stands at 5.50% as of August 30, 2022, plus one percent.
Additionally, as part of the agreement, you promise to pay the loan back within five years (unless the funds were to purchase a primary home). Payments must be made at least quarterly and in substantially equal payments. The remaining funds in your 401(k) are used as security for the loan. Lastly, if your took out a loan of more than was allowed, the overage will be considered a taxable distribution. You will also owe the 10% early withdrawal penalty if you are under age 59 1/2. For example, you borrowed $10,000 but you only had $16,000 in your 401(k). The maximum amount you should have taken was $8,000 (1/2 of the account balance). The excess $2,000 will be deemed distributed and treated as taxable income during the year the loan was taken.
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 5.50% as of August 30, 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.
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.
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).
Read More: Solo 401(k) Loan Calculator
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.
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
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.