Solo 401(k)’s most touted feature is its uniquely large annual contribution limits ($46k – $102k). A lesser known feature may be just as useful for some: participant loans.
What is a participant loan?
A Solo 401(k) participant can borrow up to either $50,000 or 50% of their account value with the following terms:
- To be repaid over an amortization schedule of 5 years or less
- Regular payments no less frequently than quarterly
- At a reasonable rate of interest… generally interpreted as prime rate + 1%
Under what conditions is this allowed?
Any. As long as the plan documents allow for it & the proper loan documents are prepared and executed, a participant loan can be made for any reason.
When is this useful?
This can be useful when someone is thinking about distributing money out of their Solo 401k plan for some reason. I recently talked to a man who was going to distribute his 100k IRA to pay for finishing the repairs of 2 fixer upper houses. After we spoke, his strategy was amended to instead:
- Setup a Solo 401k plan (adopted by his business) and transfer IRA funds into it
- Take a participant loan of $50k
- Use the loan proceeds to finish rehabbing Property #1 (which was owned personally free & clear)
- Do a cash out refinance on Property #1 once rehab is complete
- Use refi proceeds to finish rehabbing Property #2 & pay back the Solo 401(k) participant loan
In his situation, it made sense to pull some equity out of Property #1 to pay for the completion of Property #2 (and the early repayment of the participant loan) because the rental income (upon completion) of Property #1 covered about 350% of its new loan payments.
The result of the new strategy
- Avoided IRA distribution
- Avoided $35,000 in distribution taxes
- Paid participant loan back within a few months
- The rental income of Property #1 will payoff its mortgage within 6 years (with maximum principal reduction payments)
- Left $100k in his retirement account for maximum tax deferred growth
There are many other common uses for a Solo 401(k) participant loan. If a person wants to make a <$50k investment that would otherwise be a prohibited transaction, they can just borrow the money and do the investment as an individual.
What other uses can you think of?