Solo 401(k) Loans, Avoid IRS Pitfalls When Borrowing from Yourself
For the small business owner 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. For small business owners in this position, it's important to understand 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 one option that isn't available to owners of IRAs and SEP IRAs—access to funds via a built-in plan loan feature. Solo 401(k) owners can borrow from their own accumulated retirement savings when the need strikes. Understanding the rules is key to avoiding deemed distribution treatment and unnecessary penalties.
Solo 401(k)s: The Basics & 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 ½ unless an exception applies).
Like any traditional 401(k), a solo 401(k) plan document can include provisions allowing for plan loans, subject to IRS limits and rules. In the case of a solo 401(k), the account owner is 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: The IRS Rules
A plan loan is not a distribution. When a business owner takes a 401(k) plan loan, they're borrowing from their own accumulated account balance and agreeing to repay the funds later.
The IRS limits the amount of a plan loan, so that it cannot exceed (1) 50 percent of the vested account balance or (2) $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 (i.e., the $50,000 cap applies across all plan loans).
Remembering that the plan loan is, in fact, a loan, 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 in the case of a 401(k) loan taken out to finance the purchase of the client's primary residence).
The IRS expects that the quarterly payment amounts be substantially equal. It's not possible to borrow the funds and simply repay the lump sum at the end of the five-year period. If the business owner uses a payroll system to "pay" themselves, the loan repayments can be deducted via this system.
Again, because the loan is a loan, interest will also apply. The key difference between a plan loan and a traditional loan is that the business owner is paying themselves the interest. Typically, the plan document sets the interest rate determined by the prime rate plus a certain percentage (i.e., prime plus 1%).
The details for taking the loan itself will be contained in your plan document. Many business owners contact their plan administrator for the details and paperwork.
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 impact on the borrower's credit score. If the borrower repays the loan 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 be used for specific purposes.
In terms of risk, most obviously, the loan or distribution will reduce the borrower's 401(k) account balance. Less money in the account means that the taxpayer's investment returns could suffer (the interest requirement can mitigate this risk).
The risk of default—or failing to repay the loan—also exists. If the borrower defaults on the loan, the entire balance is considered a taxable 401(k) distribution. The borrower will be taxed at their ordinary income tax rates and, if they're under age 59 ½, a 10% penalty will apply.
When it comes to interest, the borrower should understand that interest payments are made with after-tax dollars that will be taxed again once they are eventually withdrawn from the account down the road.
Conclusion
Before taking a loan from a solo 401(k), it's important to understand the IRS rules and requirements—and to weigh the benefits against the potential risks. Every client is different. The availability of the plan loan option may be a significant motivating factor for a small business owner who worries about their ability to access the funds when the unexpected occurs.