Solo 401k Participant Loan vs Distribution

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When you open your Solo 401k, your goal should be a comfortable and, hopefully, wealthy retirement. Although this is retirement money, it’s still your money. If you find you seriously need money with no other reasonable sources available, your Solo 401k has options that can help. But keep your clear objective in mind. Your Solo 401k goal is a long-term commitment for your retirement, not a short-term cash fund. If you must, be sure you take funds out as responsibly as possible.

What’s the Difference Between a Loan and Distribution?

We’ll get to the difference between a loan and hardship distribution shortly. First, it’s helpful to understand the difference between a hardship distribution and an early withdrawal. A hardship distribution is when you take money early from your 401k because of an immediate and urgent financial need. While early withdrawals (made before age of 59 1/2) normally come with a 10% penalty. This penalty does not apply to most hardship distributions. Ordinary income taxes do apply to hardship distributions.

Generally, a loan from your Solo 401k provides the best financial outcome unless you have very little or no hope of repaying the loan. As you repay the loan, you not only avoid taxes and penalties, but also pay interest to yourself as a return investment. Paying interest to yourself softens the financial impact of taking out money but does not completely eliminate the impact. The interest you are paying yourself only begins compounding again after it is repaid. Interest that would have compounded during the repayment period will be lost permanently.

More importantly, you may have to reduce or stop making contributions to your Solo 401k during the time the loan is being repaid. This results in the loss of your annual tax deferrals as well as slows the growth of your retirement savings. Although a loan is generally preferred over withdrawals or distributions, a loan still has an impact on your retirement in some way.

Check out a link to the general IRS descriptions for hardship distributions, early withdrawals, and loans.

Basics to a Solo 401k loan

A participant loan lets you borrow money from your retirement savings and pay it back to yourself over time, with interest — the loan payments and interest go back into your retirement account. You can have more than one loan outstanding at the same time. However, under IRS rules, your total loan limit for all loans is restricted to $50,000 or 50% of your account balance, whichever is less.

There are many more benefits to a Solo 401k loan compared to a hardship distribution or early withdrawal. For many people, the biggest advantage is how flexible participant loans can be. These loans can be used for any purpose. The funds can be used for a business startup, major purchase, vacation, or something else. Alternatively, a hardship distribution can only be used under very limited circumstances (more to come about this) and an early withdrawal is very expensive.

Every Solo 401k by Nabers Group automatically includes the ability to take out a participant loan. Since interest deposits back to yourself, a participant loan is also known by the phrase “Be Your Own Bank”. It could be a better option than using a credit card or taking out a loan that could have a higher interest rate.

Check out two more IRS links to help you understand if a Solo 401k participant loan is the right decision for you:

IRS rules for 401k loans.

IRS FAQ for both IRA loans and 401k loans.

Key considerations with a Solo 401k loan

  • You may have to obtain consent from your spouse.
  • You must make regularly scheduled repayments consisting of both principal and interest.
  • Loans must be amortized and paid back within five years (unless borrowing for the purchase of a primary residence which allows for a longer payback period).
  • The money you use to pay yourself back is done with after-tax dollars.

One risk to consider is that if your financial situation does not improve and you fail to pay back the loan, it will likely result in penalties and interest.

Basics to Solo 401k hardship distribution

A hardship distribution permanently removes money from your retirement savings for your immediate use. You’ll have to pay taxes on the additional income if it is not a qualified Roth 401k distribution (more about Roth distributions below). There is also the possibility that the additional income will put you in a higher tax bracket.

The IRS applies strict rules to hardship distributions. Taken only if the withdrawal:

  • is due to an immediate and heavy financial need.
  • must be necessary to satisfy that need (i.e., you have no other funds or way to meet the need).
  • must not exceed the amount needed by you.

Read on for more qualifications requirements.

Hardship Distribution Considerations

Under the provisions of the Pension Protection Act of 2006, the financial hardship needs can include the employee’s non-spouse, non-dependent beneficiary. IRS acceptable reasons for a hardship distribution:

  • Medical care expenses for the participant, his/her spouse, dependents, or beneficiaries.
  • Costs directly related to the participant’s purchase of his/her principal residence (not including mortgage payments).
  • Amounts necessary to prevent the participant’s eviction from, or foreclosure on, the participant’s principal residence.
  • Funeral expenses for the participant, his/her spouse, dependents, or beneficiaries.
  • Tuition and related expenses (fees, room and board, etc.) for the next 12 months of post-secondary education for the participant, his/her spouse, dependents, or beneficiaries.
  • Expenses incurred to repair damage to the participant’s principal residence (restrictions apply).

Hardship distributions are subject to income tax. If the hardship does not meet the above requirements and you are not at least 59½ years of age, the 10% withdrawal penalty will also apply. (IRS exceptions to tax on early distributions.)

Withdrawal limits are present here as well. A hardship distribution may not exceed the amount of the need. However, the amount required to satisfy the financial need may include amounts necessary to pay any taxes or penalties that may result from the distribution.

Can I pay this back? How can I avoid penalties?

Tax rules do not allow you to pay this money back into your retirement account after the hardship has passed and your financial situation improves. You can resume making contributions up to the annual limit, but the money cannot be repaid that was taken out.

You may also qualify for a penalty-free distribution if you meet one of the following exceptions:

  • become totally disabled.
  • medical debt exceeds 7.5% of your adjusted gross income.
  • court order requires you to give the money to your divorced spouse, a child, or a dependent.
  • separated from service (permanent layoff, termination, quitting, or early retirement) in the year you turn 55, or later.
  • separated from service, and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59 1/2, whichever is longer.)

Roth Solo 401k Hardship Distributions

It makes a difference after-tax money funds a Roth Solo 401k. You can withdraw contributions anytime without owing additional income tax. This applies only to your contributions, not to the earnings on the contributions. You must follow the five-year rule before withdrawing contributions. Additionally, if you withdraw funds before age 59 1/2, you will owe the 10% penalty. Otherwise, the same rules that apply to a Solo 401k hardship distribution also apply to a Roth Solo 401k hardship distribution. You also have the option of taking out a Solo Roth 401k loan that does not trigger taxes or an early withdrawal penalty.

Here are other possibilities you may want to consider:

Special note: Many people do not know that their Solo 401k is protected from bankruptcy. In many (but not all) cases, it is also shielded from creditors. If you are experiencing financial hardship and think that you may end up filing bankruptcy, it is not wise to cash out your Solo 401k plan. Your creditors cannot take your Solo 401k money.

Before you make a final decision, consider the 7 ways to get money out of the Solo 401k. Also, consult your financial advisor or estate planning professional.

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