One of the benefits of the Solo 401(k) is the ability to borrow from the plan.

As a qualified employer 401(k), a Solo 401(k) can issue a participant loan — just like a larger employer 401(k) style plan.

For the self-employed entrepreneur, this access to capital can be a game changer if used wisely. You can temporarily tap your retirement savings to grow your own business or engage in lucrative investment opportunities that may not fit well within the self-dealing restrictions of the 401(k) umbrella.

When you borrow from the plan, you do have an obligation to repay the plan on specific terms. However, how you use the money is up to you — the borrowed funds are now outside the plan.

How a 401(k) Loan Works

The tax code allows for 401(k) retirement plan savers to borrow a portion of their funds. The terms of the loan are outlined in the tax code, and the loan features offered by any 401(k) plan must be designed within certain criteria.

You may borrow the lesser of $50,000 or 50% of your plan account value.

A loan has a maximum term of 5 years. If you plan on using the loan to purchase a primary residence, this term can be longer.

Loan interest is set at one percentage point above the prime lending rate as of the start of the loan. Loan payments must be made on a straight-line amortized basis, with payments made at least quarterly.

Each participant in the plan is treated individually.  If both you and your spouse have savings in your Solo 401(k), you may each take out your own loan.

You may take up to 3 loans at any time, as long as you don’t exceed your borrowing limit. There is no pre-payment penalty.

If you fail to repay the loan or miss making quarterly payments, then the balance of the loan is treated as a taxable distribution to you. If you’re under age 59 ½, a 10% penalty for early distribution will also apply.

You Administer the Process

One of the nice details about a self-directed Solo 401(k) is that you’re in charge of the whole process. You don’t need to apply to an outside party for approval or pay fees for someone to administer the loan.

As the trustee and administrator of your 401(k) plan, it’s your right and responsibility to run the plan — including the loan feature. You’ll stay in the clear as long as you maintain the proper documentation for the loan and can show that payments have been made on schedule.

When you take out a loan, you’ll fill out a few forms and then issue funds from the plan to yourself. You then need to be sure to make regular payments on a monthly or quarterly basis until the loan is paid off.

Common Loan Uses

Tapping your retirement savings with a loan only makes sense if there is a strong positive benefit in the use of the funds. This isn’t a good strategy to buy a new car or pay for a child’s wedding.

Some of the ways we have seen clients use the Solo 401(k) loan include:

• Startup costs for a new business
• Expansion capital for a business
• To purchase equipment for a business
• Paying off higher cost debt
• As a source of down payment funds for a primary residence
• To engage in a real estate flip transaction personally

Funding Your Own Business

The Solo 401(k) participant loan is a simple low-cost way to bring capital into a personal business venture when the capital needs are relatively low.

Whether you’re starting a business, expanding a business, or looking to acquire a piece of equipment to make your business run better, being your own bank and paying your retirement plan some interest can be a lot simpler than going to an actual bank.

The access to this extra chunk of capital can be the difference that allows you to make the leap and be your own boss or take your fledgling business to the next level.

If your capital needs are larger than the $50,000 cap you will have access to with the Solo 401(k) loan, you may want to consider a Business Funding IRA, which would allow you to tap the full balance of your existing retirement savings.

Accelerating Debt Paydown

We recently worked with a client “Mike” who had accumulated $20,000 in credit card debt due to a layoff and period of unemployment.

Mike had since created his own business and was starting to do okay, but the debt hanging over his head was holding him back.

We ran the numbers and found that using the Solo 401(k) loan to pay off the credit card would allow him to pay off that debt much sooner and save him a considerable amount in interest.

Mike was comfortable with being able to commit to the approximately $400 per month necessary to borrow from the Solo 401(k), so we used that as a guide to make the comparison.

Mike was thrilled. He learned he would be able to pay off the debt two and one-half years faster — and save $11,795 in doing so.

Even better, the $3,903 in interest payments were going into his own 401(k) plan, not to some credit card company.

A Personal House Flip

Flipping houses isn’t always the best strategy for a self-directed Solo 401(k) or IRA.

Because of IRS prohibitions against any kind of self-dealing, you must remain at arm’s length from your investments. That means you can’t put any work into the project personally.

If your plan engages in a regular pattern of flipping — which is considered a business activity — then it becomes exposed to taxation on Unrelated Business Taxable Income. This tax can get to be as high as 37%.

While occasionally having your plan participate as an equity partner in a flip run by a 3rd party can work and be very profitable, a focus on flipping with the plan generally does not make sense.

However, tapping the Solo 401(k) loan to engage in a flip transaction personally can be smart in the right situations:

• If you borrow $50,000 from your plan at an interest rate of 7.25%, then you will have a monthly payment of $995.97.
• If your flip project takes 6 months to complete, that means a total cost of $5975.82 of which $1468.25 is interest earned by your plan.

By comparison, if you borrowed that same $50,000 using a hard money loan from another investor, you might expect to pay 3 points up front as well as 15% interest with an interest-only payment.

The total cost on that loan might be around the same amount. But when you use a hard money loan all the money will go to the lender, rather than $1,468 going back to your plan as interest. The hard money loan then effectively costs 25% more.

Saving $1,500 on a flip may not in itself be a reason to consider using the Solo 401(k) loan to fund your own transaction.

If access to that amount of capital allows to pull off a flip you may not have been able to do otherwise, or if it enables you to ramp up your flipping business from one project at a time to two at a time, then there may be a real benefit.

Consider the Opportunity Cost

The down side of the Solo 401(k) loan is that your plan is receiving a moderate amount of return.

As of this writing in late 2022, the interest rate would be 7.25%. If instead of borrowing from your plan, you have the opportunity to put your plan capital to work in an investment that will generate higher returns — such as perhaps 12-15% interest being a hard money lender — this could be the better long term path.

The Solo 401(k) participant loan can have several beneficial uses, but needs to be used wisely. Please contact the experts at Safeguard today if you have any questions about borrowing from your Solo 401(k)»