Does the stock market volatility keep you awake at night with anxiety? Does the possibility of negative bank interest rates seem ludicrous? Those are merely two of the biggest reasons why the flexibility of alternative investments available with a Solo 401k account makes so much sense today. These alternative investments give you total freedom for what, when, and how you make investments.
There are many high earning investments. These include real estate, tax liens, cryptocurrency, and precious metals.
Tap Into Alternative Assets
Private Lending is one alternative that offers relief from stock market volatility and also significantly higher interest rates than FDIC insured savings accounts. For decades, private investors and large institutions alike have benefited from higher-than-average returns by investing in notes. Private loans typically offer interest rates ranging anywhere from prime rate plus 1% up to 15%. It depends on the risk involved in the deal.
When your Solo 401k is a private lender, you are the bank!
Some individual thinkers prefer private lending (through their Solo 401k) rather than real estate ownership that can require a high amount of asset management. Imagine using your retirement account as a small lending institution.
Solo 401k Private Lending as a Profitable Investment Option
As the trustee of your Solo 401k plan, you decide and negotiate all terms of the note including the rate of interest. This gives you unparalleled control over your investment. Often called a “promissory note,” it is also known simply as a “note” or “private debt.” In its most basic form, a promissory note is a legal document stating that a borrower will repay a loan within a specified time and at a specified interest rate. This is the essence of private lending. Concerning your Solo 401k (or self-directed IRA), the Solo 401k funds the loan and receives loan payments back into the Solo 401k (tax-free).
Although these are private loans, notes have commercial value. That is demonstrated by secondary markets where you can purchase existing notes or sell a note that you originate. The market (and you) typically value a note based on four primary factors.
- The total amount to be repaid (includes principal, fees, penalties, and other charges).
- The interest rate charged.
- The frequency of payments and the total amount of time allowed to repay the loan in full. This includes principal, interest, and other fees.
- The risk of default or failure to make timely payments (includes factors like borrower’s creditworthiness and collateral as security).
The risk of default is a significant factor when determining the rate of interest. A secure note will have a lower rate of interest. That’s because if the borrower defaults, the Solo 401k can take legal possession of the collateral. Then, you can sell it to recover the outstanding debt. The only remedy for an unsecured note that defaults is for the Solo 401k to pursue legal action against the borrower (sue).
Unsecured loans command a higher rate of interest than secured loans.
Solo 401k Process for Private Lending
You don’t have to have a Solo 401k to make a private loan but a Solo 401k does increase your earnings through powerful tax advantages. But before you make a private loan with maximum tax advantages, you need to be aware of a few IRS Rules.
- Loan funds cannot come from a disqualified person. However, you can combine Solo 401k funds with other sources (not including a disqualified person).
- Similarly, don’t lend funds to a disqualified person in Solo 401k private lending deal
- Disqualified people cannot benefit from the activities resulting from the loan. For example, a disqualified person cannot use a car purchased with the loaned money. This is known as “self-dealing.”
- The loan should have a stated interest rate of at least Prime.
- All loan payments (including principal, interest, and fees) must be paid into the Solo 401k account.
- Although not an absolute requirement, it is highly suggested that the loan terms be documented in a loan agreement or promissory note.
How to Start Private Lending
This is obvious but the first step in a Solo 401k private loan is setting up your Solo 401k account. You’ll also have to fund your Solo 401k with either rollovers from other retirement plans, or contributions to the plan based on your small-business earnings.
As soon as these activities are complete, you (as the trustee) are ready to begin the loan process. You can complete the loan process yourself. Alternatively, you might choose the services of a loan-servicing agent or attorney. As the trustee, give your input on terms of the deal. This includes the interest rate, payment schedule, qualifying the borrower, when the loan is due, and other important conditions of the loan.
Once you draw the loan agreement, review it for compliance with your Solo 401k plan requirements and regulations. It’s important to use the name of your Solo 401k (not your personal name) on all loan documentation. Have the borrower send loan payments to your Solo 401k bank account (not your personal bank account).
Solo 401k profits are tax-deferred (or tax-free with a Roth Solo 401k).
Solo 401k Private Loan Case Study
Maybe you want to make your first private loan to a trusted borrower such as a close friend (Gary). Perhaps Gary owns and operates a seasonal business at a seaside resort selling souvenirs and snacks. Each year he buys fresh inventory shortly before the summer season begins. This year Gary doesn’t have the capital available to purchase the inventory.
Gary needs a loan quickly to be ready for the short summer season. He applies to the local bank for a small business loan but he’s told it will take a minimum of two months to process the loan. That’s not going to work because he needs to order $20,000 of inventory within two weeks so that his shelves are stocked within one month. He’s your friend, he’s in trouble, and your Solo 401k has the funds that will keep him in business until he repays the loan in four months. You know Gary’s sales from the souvenir stand will pay your loan back, and then some. So, you decide to do a private lending deal to Gary from your Solo 401k.
Here is a very simplified version of a promissory note that you and Gary agree to at 9% interest.
The principal is the initial amount of credit provided ($20,000). The maker of a note is the party who receives the loan (Gary Owner) and promises to pay the note’s holder. The payee is the party that holds the note and receives payment from the maker when the note is due (the name of your Solo 401k).
Calculating the interest is simple because the note will be paid in full (including interest) near the end of the summer season after the inventory is sold. Interest on short‐term notes is calculated according to this formula:
Calculating the interest on this loan is $20,000 X 0.09 X 4/12 = $600.
That’s much better than the interest rates that banks are offering and without the volatility of the stock markets. And it’s passive income because no one had to manage a rental property. For the rate of return on your investment, it doesn’t get much better than this…. But it could…
At your discretion, you may or may not require Gary to put up the inventory to secure the loan. Gary also owns (with a mortgage) the building that his store is in. Another option you have is asking Gary to list the loan from your Solo 401k as a second mortgage on the building. But you’re probably not going to do that because of the cost and complications involved with recording a second mortgage. The inventory is fine with you as security but because you are in complete control, the second mortgage is a flexible option you also have.
A Private Loan from your Solo 401k helped a friend and added a nice amount to your retirement plan tax-deferred!
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.