If you are self-employed and utilize a Solo 401(k) plan to save for retirement, you can usually borrow from the plan. A Solo 401(k) 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 401(k) loan, along with the pros and cons of taking one.
What is a Solo 401(k)?
A Solo 401(k) 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 401(k) 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 401(k) 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.
The Solo 401(k) Loan
If allowed by your plan, you may utilize a Solo 401(k) loan. You may borrow up to 50% of your account balance or $50,000, whichever is less. The IRA Financial Group Solo 401(k) plan does allow you to borrow money from the plan. Not all Solo 401(k) facilitators allow this. It’s an important feature to have as a plan participant. While some financial experts argue against taking a loan from your 401(k), it can be an important financial tool if done the right way.
Taking Out a Solo 401(k) Loan
Assuming your plan provider allows it, a Solo 401(k) 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 5.5% as of 2/1/19, 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 you 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.
Pros and Cons of a Solo 401(k) Loan
The Benefits of the Solo 401(k) 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 401(k) 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.
The Risks of a Solo 401(k) 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.
A Solo 401(k) 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 401(k) 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.