One of the most enticing benefits of establishing a Solo 401(k); however, keep in mind:
- You need to qualify for the 401(k) in that you can tie back the 401(k) to your business (learn how you may qualify for a Solo 401(k)
- If you take advantage of this benefit, remember this is a legally-enforced loan and you must treat it as such. It is not your “piggy bank”, and you must strictly comply with the loan’s requirements.
You may have been a W-2 employee participating in a company’s 401(k) plan. As part of your participation in the plan, you were most certainly informed of your ability to exercise a participant loan from the plan. You may have even taken a loan and, if so, you know you were required to repay the loan. Most likely, your employer took monies from your paycheck to repay the loan on a per-pay-period repayment schedule.
But, as both the Trustee and participant of your Solo 401(k) plan, are you aware that you can exercise loan(s) from your Solo 401(k)?!
Yes, you can!
Now, the first thing to keep in mind is that your plan documents must permit such loans. The good thing is that all FSD plan documents permit participant loans.
Solo 401(k) Loan Rules
As both the Trustee and participant of your Solo 401k, you can both authorize (as Trustee) the loan option and exercise (as participant) a loan from the plan. But, what are the rules for taking out the loan? Obviously, a loan is a loan, so there must be some rules governing this option, correct?
Yes, as a participant, you can :
- Borrow up to either $50,000 or 50% of their account balance, whichever is less;
- The loan must be paid in 5 years (or less) on an amortized loan repayment schedule;
- The loan must be repaid on nothing less than a quarterly basis (yes, you read that correctly, no paying the loan semi-annually, annually or a “balloon” payment at the end of the 5 years);
- There are no pre-payment penalties;
- The interest rate for the loan must be reasonable based on current prime. “Reasonable” rate of interest is defined as at least the current prime rate + 1%. For example, if the prime was 3.5% at the time of the loan, you must re-pay the loan at a percentage of at least 4.5%.
Is There Loan Flexibility — What if I Miss or Don’t Fully Re-Pay the Loan?
Well, the simple response is don’t let yourself get to that point. As noted, the loan and the loan documents are legally-enforceable documents. While it is permissible to take loan(s) from the plan, strict compliance on following the terms is a must. Simply speaking, if you default on your loan, any and all outstanding balances will be considered to be in default and considered distributed. As such, you would owe taxes on the distribution and be subject to the 10% penalty tax if the event occurred prior to 59 1/2. Bottom line….be diligent in adhering to all rules for the loan.
But, think if you follow the rules for the loans…you can use these funds for any purpose whatsoever. Whether you need the funds for living expenses, paying off high debt, OR utilizing the funds for any investment purpose including real estate, funding a new business and a whole laundry list of what you might want the funds for.
In addition, the loan is received tax and penalty free and will continue to be tax and penalty free….provided you follow all repayment terms for the loan.
Benefits to a Loan
Well, let’s use the obvious. If you needed a loan to start a new business or aid your current business, how successful might you be going to your local bank? As you know, banks have severely restricted one’s ability to secure a loan. As a business owner you may just need access to funds for business purposes…now you can!
Some other examples of the benefits to a Solo 401(k) loan:
- Consolidate outstanding debt;
- Pay for family expenses or emergencies;
- Lending to others;
- Invest in other investments opportunities that you may not want as part of your 401(k) investment portfolio
- Take a loan vs. a taxable distribution from your plan;
- Invest in a transaction that would otherwise be a Prohibited Transaction under Internal Revenue Code Section 4975