For small-business owners dealing with uncertainty over cash flow and general business needs, saving for retirement often takes a back burner. Stashing cash in an account that the owner won't be able to access for many years without fear of penalty can discourage retirement savings entirely.

It's important to understand, for such owners, that options do exist — and that a workable retirement savings program and access to funds in a pinch are both possible. Solo 401(k)s are powerful retirement savings vehicles for entrepreneurs and small-business owners without full-time employees.

Solo 401(k)s also offer an option not available to owners of individual retirement accounts and SEP IRAs — access to funds via a built-in plan loan feature. While solo 401(k) owners can borrow from their accumulated retirement savings, understanding Internal Revenue Service rules and requirements is key to avoiding deemed distribution treatment and unnecessary penalties.

Solo 401(k)s: Basics and Background

Small-business owners who establish solo 401(k)s can contribute to those accounts as both employer and employee. Only business owners, partners and their spouses are permitted to participate in the plan.

Solo 401(k)s are funded with pre-tax dollars. Distributions are taxed as ordinary income, and an early withdrawal penalty will apply to distributions taken before age 59.5 unless an exception applies.

Like any traditional 401(k), a solo 401(k) plan can allow for plan loans, subject to IRS limits and rules. In the case of a solo 401(k), account owners are both the participant and the plan sponsor — meaning that they are responsible for including a provision for plan loans in their formal plan document.

Plan Loans: IRS Rules

A plan loan is not a distribution. When business owners take a 401(k) plan loan, they're borrowing from their accumulated account balance and agreeing to repay the funds later.

The IRS limits the amount of a plan loan, so that it cannot exceed 50% of the vested account balance or $50,000, whichever is less. Plans may permit multiple loans or limit the participant/owner to one outstanding plan loan at a time. When multiple plan loans are permitted, the borrowed amounts are aggregated and the otherwise-applicable limits continue to apply.

The plan loan is a loan, of course, so it's important to understand repayment obligations. Generally, the  loan balance must be repaid within five years and payments must be made at least quarterly. Special rules apply for 401(k) loans taken out to finance the purchase of the client's primary residence.

The IRS expects quarterly payment amounts to be substantially equal — it's not possible to simply repay the lump sum at the end of the five-year period. If business owners use a payroll system to "pay" themselves, the loan repayments can be deducted through this system.

While interest will also apply in a plan loan, business owners are paying themselves the interest. Typically, the plan document sets the interest rate determined by the prime rate plus a certain percentage.

Details for taking the loan will be contained in the plan document. Many business owners contact their plan administrator for paperwork and other assistance.

Considerations for 401(k) Borrowers

As is true with any financial strategy, the 401(k) loan option has benefits and risks.

Tapping a 401(k) does not require a credit check and won't have an adverse effect on the borrower's credit score. If the loan is repaid according to plan, no immediate tax impacts exist. The loan can be used for either business or personal needs, where a hardship distribution requires the funds to be used for specific purposes.

The primary risk is the loan or distribution reducing the borrower's 401(k) account balance. Less money in the account means that the taxpayer's investment returns could suffer, with the interest requirement a potential mitigant.

The risk of default — or failing to repay the loan — also exists. With a default, the entire balance is considered a taxable 401(k) distribution. The borrower will be taxed at ordinary income tax rates, and a 10% penalty will apply to those younger than 59.5.

Interest payments, meanwhile, are made with after-tax dollars that will be taxed again once they are withdrawn from the account.

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