The ability to take a participant loan from any 401(k) plan, including a Solo 401(k), is an awesome feature to a 401(k) plan that permits such loans. Of course, there are rules to be followed with regard to securing the loan and repaying the loan in compliance with IRS regulations.  These rules include:

• A loan limit of $50,000 or 50% of their account balance, whichever is less;
• A loan repayment schedule of 5 years (or less) with an amortized loan schedule;
• An on-going loan repayment schedule which is repaid on, at minimum, a quarterly basis;
• No pre-payment penalties; and,
• An interest rate that is consistent with current loan interest rates.  At minimum, the loan can be reasonable if it is the prime rate (at the time the loan is taken out) + 1%.

So, while the ability to take a loan from the plan has many significant benefits (link back to article on Solo 401(k) loans), one interesting benefit is one that very few people think of. It is a benefit that, when you initially think about it you may believe you can’t do…but you can. What is this benefit that you believe you can’t make?

Using your loan proceeds to make an investment or execute a transaction that would otherwise be treated as a Prohibited Transaction (IRC Section 4975) if it was done within the plan.

Now, let that soak in for a second. If there was always an investment that you wanted to make, or a transaction you wanted to enter into, but you couldn’t enter into the transaction because it would be a prohibited transaction, you can! This is also with the understanding that the transaction was entered into after the participant took a participant loan, and the amount kept within the permissible loan proceeds you can take from the plan with your participant loan.

You already understand this concept.  Let’s use a couple of examples:

1)  Purchase of a Car — Let’s say you qualify for the maximum loan from the plan….$50,000. And, you wanted to use these funds to purchase a vehicle that you would personally own and use. This would certainly be permissible, and you probably understand that. Your mind would most likely be wired that way.

2)  Giving Money to Your Mother — If you have done any research on self-directed plans and 401(k) loans, you understand that your mother would be a disqualified person to your plan. Your mind may initially think that you couldn’t take a loan out of your plan and turn around and give that money to your mother…I mean, she is a disqualified person, right?

But, remember, the loan is a loan and not an investment of the plan. Where you could not loan your mother money as an investment from the plan as she would be a disqualified individual, you could take the loan and do whatever you wish with the proceeds. Again, remember, it is a loan to you, the participant, and NOT an investment from the plan. You can, in effect, do whatever you wish with those funds.

It is interesting that in using these two examples, most everyone would agree that in example #1 there would not be any problem…but, if you did not give example #2 much thought, your first blush reaction might be that it could be a problem. But, the simple fact is that as long as the funds are received by the participant as a legitimate participant loan AND the participant fully complies with the repayment schedule and criterion, the participant can do whatever they wish with the funds.

Just an interesting way of looking at Solo 401(k) loans and some of the freedom you have with this tool. Just remember to follow the rules.

As always, the information is intended to be educational in nature. It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice. You must always consult with your respective professional in all such matters.