Having financial options is a good thing. Today, there are several options available to leverage money in ways that can you make more money for your retirement. Of course, a credit card is one of the easiest ways to borrow money. The internet is full of examples of people buying real estate using credit cards. That makes it a reasonable assumption that you can probably use a credit card in conjunction with your Solo 401k or self directed IRA. Unfortunately, the almost universal answer is that you cannot have a credit card issued in the name of your Solo 401k or your self directed IRA. Also, you cannot use a credit card in your name involved in transactions for the benefit of your Solo 401k or self directed IRA.
The IRS Technical Catch
Technically, there is no IRS rule specifically prohibiting your Solo 401k plan from having a credit card. The catch in IRS regulations comes from how borrowed funds used by the Solo 401k are secured. Your Solo 401k can take a non-recourse loan because it is only secured by the asset being acquired. By definition, a non-recourse lender cannot take financial action against the Solo 401k participant/trustee or any other assets in the Solo 401k plan. If there is a default or foreclosure, the lender can only recover the real property.
Also important is that qualifying for a non-recourse loan does not involve collecting personal information about you. It only needs information about the asset securing the loan. The problem with a credit card is that it requires checking your credit score, verifying your employment, copies of your W-2s, and other personal information.
Most importantly, obtaining a credit card requires that you personally guarantee that the loan will be repaid. The personal guarantee is the IRS technicality. The rule that applies falls under IRS Code for prohibited transactions defined by section 4975(c)(1)(B) when account holders guarantee the loan. The IRS phrase is “lending of money or other extension of credit between a plan and a disqualified person.” A recent court case finding of a prohibited transaction resulting from guaranteeing a loan is James E. Thiessen et ux. v. Commissioner; 146 T.C. No. 7; No. 11965-10.
Still, the reality is that Solo 401k transactions require that you be able to issue funds from the account. Fortunately, you have plenty of other good options available to issue Solo 401k funds. Check writing, debit cards, ACH, wires, and cashier checks are all permitted. Credit cards and personal lines of credit that are not.
Fortunately, there are also ways that you or your Solo 401k can borrow money based on the assets in your Solo 401k.
No Credit Cards for the Solo 401k
You may need to borrow for large purchases, to grow your Solo 401k, or when you need emergency funds. Credit cards are seldom a smart way to borrow whether the funds are needed for personal use or to grow your Solo 401k.
One of the biggest drawbacks of credit cards is that these accounts are specifically designed to keep you in debt and paying on them for as long as possible. The longer you borrow the money for, the more interest the credit card company collects. When the interest and fees are added in, the minimum monthly payment is typically designed to keep you paying on the account for 10, 20 years or longer. Even in these times of ultra-low interest rates, credit cards are still charging an average interest rate well above 16% (Bankrate, April 2020).
Credit card companies are also great for tacking on a long list of extra fees that include:
- Annual Fees
- Balance Transfer Fees
- Cash Advance Fees
- Over-Limit Fees
- Late Payment Fees
- NSF Returned Payment Fees
- Foreign Transaction Fees
Obviously, you need better options to manage your finances.
Your Solo 401k Has Smarter Ways to Borrow Money
Each Solo 401k by Nabers Group automatically includes a participant loan, where you can take a personal line of credit of up to $50,000.
Important Note: Because of the COVID-19 virus, the U.S. Congress CARES Act has significantly increased the access to your Solo 401k funds. The loan cap is raised from $50,000 to $100,000. It also waives the 10% penalty for early withdraw and allows taxpayers to later restore any withdrawn funds. This can be up to 100% of the vested account balance. Suspended loan payments will probably be deferred up to a year, which could extend the 5-year loan repayment period to 6-years.
Loans from your Solo 401k have many advantages over other loans (especially credit cards). These include:
- No credit checks or qualifying since you are essentially loaning the money to yourself.
- The loan can be used for any purpose (many are used for personal reasons).
- Avoids IRA or 401k distribution if you were to withdraw the funds instead of borrowing. Costly income tax and fees become due with a distribution.
- Little or no paperwork needs to be filled out.
- You can send yourself the funds from the Solo 401k immediately.
- Prime plus 1% is a very good interest rate that typically banks reserve for only their best customers.
- You repay the low-interest rate back into your own retirement account.
When to Use a Solo 401k Participant Loan
A few good reasons to use a 401K loan are:
- Startup money for a new business.
- Down payment for your primary residence.
- Emergency funds.
- Paying off high-interest credit (including credit cards).
Consider a Non-Recourse Loan
A non-recourse loan can free up cash inside Solo 401k for other investment uses. You could grow your real estate holdings by leveraging one property for a down payment on additional real estate purchases. You could use the funding to make improvements before selling a property. Non-recourse loans can put you in control of a million dollars of assets or more although you only own a couple of hundred thousand in assets. Leverage can earn you a lot more towards your retirement.
To be clear, non-recourse loans are available to both a Solo 401k and a self directed IRA. But a very good reason a Solo 401k is preferred is that unrelated debt finance income tax (UDFI) applies to a self directed IRA but not to a Solo 401k.
Whether you are looking for credit to grow your retirement nest egg or need personal cash, credit cards don’t make good financial sense. But looking into your retirement account does. Inside your retirement account, you want to look at a non-recourse loan that protects your personal assets because you do not personally guarantee the loan. For credit needs outside of your retirement account, you can still access the funds with a personal Solo 401k loan or line of credit. The substantial loan cap can easily finance a small business if you want to create a new income stream for your current and future financial needs.
Have questions about growing your retirement account? The 401k experts at Nabers Group will help you get your retirement funds into your control, where they belong.