The Solo 401k loan is a very important benefit of a solopreneur’s retirement plan.  IRAs (even SEP IRAs) do not permit loans!  It’s important to follow the rules if you ever need to use this benefit.  In this post, we will explore the specific benefits, pitfalls, and rules of the Solo 401k loan.  By the end of this post you will know exactly how to use a Solo 401k loan.

What is a Solo 401k loan?

A Solo 401k loan is exactly what is sounds like.  You loan a portion of your balance from your tax-advantaged Solo 401k plan to yourself, personally.  Then, you pay back the loan with interest to your 401k plan; basically you are paying back your future self.  The loan provisions are custom-tailored to suit your needs.  Overall, it is a very flexible arrangement.

What are the Solo 401k loan rules?

The loan is not a free-for-all.  You must follow some rules to keep your loan in compliance.

1. You are limited to a maximum 5 year payback period.  If you use the loan proceeds to buy a primary residence then you can elect a payback period up to 30 years.
2. You must pay yourself interest in a timely manner.  You cannot charge an absurdly low interest rate either.  Typically, loan agreements use the Prime Rate plus a fixed percentage.
3. You are limited to a maximum loan of $50,000 or one-half of your plan balance, whichever is less.
4. If you end employment in your business you must pay back the loan immediately or suffer financial penalties.

What makes this loan better than other loans?

• You are completely in charge of your Solo 401k loan.
• You can take the loan for whatever reason you want.
• You do not need a third party to underwrite it, so you can receive your loan proceeds quickly.
• Since you are paying yourself interest, the overall cost of this loan is typically lower than other loans.
• Origination fees are very modest, or sometimes even zero.

What are the pitfalls of a Solo 401k loan?

• You lose the ability to invest your loan proceeds in a tax-advantaged account.
• You pay tax on the interest twice:  Once when you earn the money to pay the interest and again we you take the interest out in retirement.
• If you default you may owe early withdrawal penalties, underpayment penalties, and ordinary income taxes.

A real-life example.

A few years ago one of my clients was about to close a real estate deal, but fell short on funds to complete it.  Fortunately, she had a Solo 401k from which she took a loan of $50,000.  The origination process was quick and she closed her deal successfully because she didn’t need approval from a third party.  The terms of the loan were very favorable to her.  She created a loan agreement that provided for the Prime Rate as published in the Wall Street Journal (3.25% at the time) paid back over five years.  The payments could be made quarterly, and if she was late she gave herself until the end of the quarter to rectify the default.  She saved her real estate deal (which turned out to be a success) and paid off her Solo 401k loan in just 18 months.

Now, I do not recommend opening up a Solo 401k with the intent of using it as a loan facility; however, if you ever need short-term funding a Solo 401k loan is hard to beat.