Solo 401(k)’s most touted feature is its uniquely large annual contribution limits ($49k – $108k). A lesser known feature may be just as useful for some: participant loans.
What is a participant loan?
A Solo 401(k) participant can borrow up to either $50,000 or 50% of their account value with the following terms:
- To be repaid over an amortization schedule of 5 years or less
- Regular payments no less frequently than quarterly
- At a reasonable rate of interest… generally interpreted as prime rate + 1%
Such a loan may only be made in accordance with the Solo 401(k) plan documents. While most plan documents disallow this type of loan, the Unlimited® 401k offered by my company does allow it.
Under what conditions is this allowed?
Any. As long as the plan documents allow for it & the proper loan documents are prepared and executed, a participant loan can be made for any reason.
When is this useful?
This can be useful when someone is thinking about distributing money out of their Solo 401k plan for some reason. I recently talked to a man who was going to distribute his 100k IRA to pay for finishing the repairs of 2 fixer upper houses. After we spoke, his strategy was amended to instead:
- Setup a Solo 401k plan (adopted by his business) and transfer IRA funds into it
- Take a participant loan of $50k
- Use the loan proceeds to finish rehabbing Property #1 (which was owned personally free & clear)
- Do a cash out refinance on Property #1 once rehab is complete
- Use refi proceeds to finish rehabbing Property #2 & pay back the Solo 401(k) participant loan
In his situation, it made sense to pull some equity out of Property #1 to pay for the completion of Property #2 (and the early repayment of the participant loan) because the rental income (upon completion) of Property #1 covered about 350% of its new loan payments.
The result of the new strategy
- Avoided IRA distribution
- Avoided $35,000 in distribution taxes
- Paid participant loan back within a few months
- The rental income of Property #1 will payoff its mortgage within 6 years (with maximum principal reduction payments)
- Left $100k in his retirement account for maximum tax deferred growth
There are many other common uses for a Solo 401(k) participant loan. If a person wants to make a <$50k investment that would otherwise be a prohibited transaction, they can just borrow the money and do the investment as an individual.
What other uses can you think of?
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You could always pull it out for the purchase of a primary residence and get a longer term. There are plenty of debates on the topic, but one of the oft-cited disadvantages is “if you get fired or lose your job, you have to pay back the loan immediately.” That disadvantage isn’t really there for a self-employed individual with a Solo 401k.
As always, it depends on the specific numbers for interest rates, but it’s nice to know it’s there as an option. I honestly have no idea when I’ll buy a home, nor how much it will cost. Rather than pitching cash into a “home” fund that’s just a standard taxable savings account, I’d prefer to put it in the 401k. If don’t end up needing it– great!
The “pull it out for the purchase of a primary residence” method is just an exclusion to the 10% early distribution penalty. So when you use that, you are distributing money from your plan to yourself that cannot be paid back into the plan. So that creates a taxable event (although avoids the extra 10% tax) whereas a Solo 401(k) participant loan is not a taxable event because there is no distribution.
Loan…
- Not taxable
- To be repaid
- Money ends up back in the plan where it can invest again in the future with tax-favored treatment
Distribution…
- Taxable
- Not to be repaid
- Money permanently exits the plan and will not receive tax-favored treatment if used for investment purposes in the future
Apples and oranges.
Jeff
Well I was still referring to a loan rather than a distribution, but I’m an admitted n00b here. Guess I shouldn’t believe everything I read on the internet.
Is there perhaps a different set of guidelines for borrowing from a Solo 401k than from a “regular” 401k? Or are these folks all just wrong?
Source: http://www.401khelpcenter.com/loans.html
Source:
http://www.money-zine.com/Financial-Planning/Retirement/401k-Loans/
Source:
http://moneycentral.msn.com/articles/retire/basics/4714.asp
Jed,
I hadn’t run across that information before. I certainly don’t know everything about retirement plans. I tend to focus on investment matters, and buying a primary residence isn’t an investment in my opinion.
I learn something new every day. Thanks
Jeff
I am struggling with a matter. I expect to be laid off here soon. I have $100K in my 401K which I will have rolled over into a either a self directed IRA, (or perhaps this Solo 401K since I will be starting a new business) I have a mortgage of $90K. I was thinking of investing my self directed IRA with a real estate broker who buys trust deeds – if he uses my investment to buy the trust deed for my house from the lender, does that create a conflict. If he uses money from more than one investor, including my IRA, to buy my trust deed, does that create a conflict?
Also, I am 58 1/3 so I want to defer payments on the mortgage as long as I possibly can since I will be unemployed and starting a new business. Cash will be tight, so perhaps the purchased trust deed and loan can be rewritten for interest only payments, or interest accrual to be paid in 2 years, or something like that
BJ,
The situation described, although indirect, would be a prohibited transaction. Read more here:
http://jeffnabers.com/2008/04/24/prohibited-transaction-basics/
Even if there were other investors who fractionally bought your trust deed, it would likely be a PT. You simply can’t direct your IRA/401k to invest in something with the knowledge or expectation that it will become part of a chain of events to involve or benefit you soon thereafter.
With a world of tremendous investment opportunities out there, it just doesn’t make sense to risk the 115%+ taxation that is applied to prohibited transactions.
Call my office to find out more about the compliant and profitable things your Solo 401k can do. 877-SOLO-401K
Jeff
This is a compelling reason to consider the Sep 401k.
Hi, there. There’s no such thing as a SEP 401k. If you meant SEP IRA, that is an alternative to the Solo 401k.
When you compare the two, it’s clear that the SEP IRA results in more taxation, less benefits, and less control.
If you’re considering a SEP IRA, you’ll have more power and control by going with a Solo 401k instead