As the coronavirus pandemic threatens financial markets and sends the U.S. economy into a potential recession, many small businesses and entrepreneurs are finding themselves in a liquidity crunch. Cash is now become king. Whether the cash is needed to pay employees, rent, mortgage payments, or even food, getting access to quick cash has become paramount. For some investors, this has forced stock liquidations at steep losses. However, a tax efficient and quick way to get cash fast for 401(k) plan participants is the 401(k) plan loan feature. Whereas, if you took a distribution from an IRA, you would be subject to tax and a 10% early distribution penalty if under the age of 59 1/2. Note – taking a distribution from a 401(k) plan requires a plan triggering event, which is typically reaching the age of 59 1/2 or leaving your job.
Tapping Your 401(k) Plan
Internal Revenue Code Section 72(p) allows a 401(k) plan participant to take a loan from his or her 401(k) plan. Of course, the business’s 401(k) plan documents must allow for one.
Tapping your 401(k) plan is permitted at any time using the accumulated balance as collateral for the loan. A 401(k) participant can borrow up to $50,000 or 50% of the 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 5.50% as of August 30, 2022.
Advantages and Disadvantages of a 401(k) Loan
Advantages of a 401(k) Loan
- Ability to get quick access to cash
- Tax-free and penalty free use of cash
- Low interest rate – Prime Interest Rate is currently 5.50% – much less than a credit card or pay day loan
- Interest is being paid back to your plan – helping increase the value of your plan. For example, a $50,000 loan at 4.25% interest will give your 401(k) plan an extra $5,764.68
- Ability to pay a higher interest rate on loan allowing one to increase value of 401k plan while gaining ability to use loan funds for any personal purpose.
- Flexible options in case of missed payments
Disadvantages of a 401(k) Loan
- Failure to pay back to loan will result in a taxable distribution and a 10% early distribution penalty if under the age of 591/2
- 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. Also – when one changes jobs, loan will become due
However, in times of crisis, such as the coronavirus pandemic, the 401(k loan feature is a great way to get quick tax-free and penalty free use of up to $50,000. You can use the cash for any purpose and do not have to start making payments back for at least three months. In addition, the interest paid back will also help your 401(k) plan assets grow. With markets falling, a 4.25% rate of return is a solid investment for your 401(k) plan and also help you out personally with a quick infusion of cash. It’s a win-win situation.
How do I Know if My Plan has a Loan Feature?
Unfortunately, not all 401(k) plans offer the loan feature as a 401(k) plan option. In general, the employer or plan document sponsor determines whether the loan feature will or will not be included in the 401(k) plan. The plan-adoption agreement is the document that indicates whether the loan feature is included as a plan option. Most large business plans include a loan option. In addition, the majority of all self-directed Solo 401(k) plans typically offer the loan feature in their plan documents. If you are not sure, ask your plan administrator or human resource department.
The Solo 401(k) Plan Solution for the Self-Employed
The Solo 401(k) plan, also known as an individual 401(k) or self-employed 401(k) plan, is an IRS approved retirement plan which is suited for business owners who do not have any full-time employees, other than themselves and perhaps their spouse. The Solo 401(k) plan is not a new type of plan; It is a traditional 401(k) plan covering only one employee. A Solo 401(k) plan is not subject to ERISA as there are no non-owner employees. For 2020, a solo 401(k) plan participant can contribute up to $57,000 or $63,500 if over the age of 50.
With IRA Financial’s Solo 401(k) plan loan feature, an entrepreneur who is self-employed individual or small business owner with no full-time employees can borrow up to $50,000 tax-free and penalty free. There are no penalties or taxes due provided loan payments are paid on time. The 401(k) plan loan funds can be used for any purposes, including buying food, paying rent, etc.
Quick Cash When You Need It
If you are in need of some quick cash and have access to a 401(k) plan loan option, borrowing from your 401(k) plan may end up being the most tax efficient way of tapping into your retirement account. The current pandemic illustrates the need for quick cash. If you have no other options, look to your 401(k) plan.