Receiving a Personal Loan From Solo 401k
Sunwest Trust is a prototype plan sponsor for Individual 401ks; many know this instrument as a Solo 401k. Also, as with a typical 401k, personal loans may be received from these arrangements. Below we will discuss the positives and negatives of such a transaction.
Personal loans are not allowed in self directed IRA plans, but an individual may borrow up to 50% of the value of a 401k. This ability is capped at $50,000 dollars, so the IRS stipulates within the rules that guide personal loans that the lesser of the two options must be used. In taking a loan from a 401k plan, the smallest amount that allowed is one thousand dollars.
Taking a Personal Loan from a Solo 401k Plan
When filling out the loan application, the borrower must list a reason for taking a loan. One may choose “any purpose”. Choosing that option enables retirement account owners to take a loan for anything they wish. 401k loans must be paid back within 5 years, with interest.
There are other facts to consider when deciding whether or not to take a loan on a retirement plan. When paying the loan, all payments, plus interest, go directly into the 401k rather than to a third party lender. The typical interest rate for a 401k plan loan is the “prime rate” as specified by the Wall Street Journal on the loan date. To find the prime rate on the day of the loan, get a copy of the Wall Street Journal and simply check.
When receiving a plan loan, pay it back conveniently by having that money easily deducted from your check. Make sure that it is set-up correctly. Simply pay on a bi-weekly or monthly basis and there is up to 5 years to do so.
When taking a loan from a 401k plan, it is a loan, so no early withdrawal penalty is involved. There is no need to worry about that early 10% withdrawal penalty since it is not a distribution. Whenever applying for a 401k loan, one’s spouse will have to sign the form to acknowledge they are aware that funds, are being borrowed, against a retirement account.
The Pros of Taking a 401k Account Loan
- No credit check: Can’t get a personal loan due to either bad or no credit? That will not be an issue with a 401k plan loan. The account is already fully funded.
- Low interest: Interest established for the loan is set at the prime rate at the time of the loan close.
- No Restrictions: Generally no restrictions on the purpose for which one may borrow.
- No early withdrawal penalty: This is not a distribution. It is a loan.
- Payments return directly into the 401k: Structured loan payments go directly to your retirement plan, with interest.
- Tax Shelter: The interest paid back is not taxable. Here are no taxes on interest paid back into the account until retirement age. Taxes are not due until funds are actually distributed.
- Lower tax rates: Generally, annual the tax bracket is lower based on earnings at the time of retirement.
The Cons of Borrowing from a 401k
- Opportunity cost: Removing money from a retirement account diminishes its’ ability to earn interest from external sources until it is returned to the account.
- Reduced Contributions: Loan repayments go back to your own 401k account so unless your income has increased, the borrower is likely making smaller contributions to the plan because income is tied up in a loan repayment.
- Default distribution: If a 401k loan goes into default, the loan becomes a distribution. Taxes and penalties are due that year. If the borrower is under the age of under 59 ½, there is an additional 10% early withdrawal penalty.
- Unexpected loan default: If a borrower is working in a company that goes out of business or the plan is closed with an outstanding 401k loan, that loan is due immediately. If the borrower cannot pay the loan, it is considered a distribution, and income tax is due on it in that year.
- Non-deductible Interest: Interest paid on the loan is not deductible. That is a good reason not to take a loan from a 401k plan.
Once the decision is made to take a loan from a qualified plan, call for a loan application and agreement from a packet we will provide. The forms are numbered 2-21, so remove those first. Once the paperwork is completed, remember to have your spouse endorse it so that they understand you are taking a loan from retirement savings. Then simply fill out the loan agreement.
Once the forms are completed, make and keep a copy for tax and personal finance records. Always make sure to keep these records in the even you are asked to show the IRS. The Internal revenue service will want to ascertain that the borrower is acting in accordance with the rules of the plan. Once approved, simply write yourself a check from your 401k checking account for the approved loan amount and remember that there are 5 full years to pay that back.
For answers to any questions any questions, speak with a CPA or a tax professional. If you have any questions for us you can go to our website, which is Sunwesttrust.com or you can call us at 1-800-642-7167.
As always, we post new videos every Tuesday @ 2 o’clock so don’t forget to subscribe to our YouTube channel. You will receive videos every week directly to your subscription inbox or you can just visit our channel at http://www.youtube.com/SunwestIRA. Thank you!