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. Solo 401k loan 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, you have many options. Our self employed clients who have their self directed 401k plans may receive regular paychecks or irregular commissions. If you have a regular paycheck pay the loan conveniently by having that money easily deducted from your check. If you have irregular pay periods, payment can be made every 90 days. In either case, the payment must be a blend of principal and interest and must be paid back within 5 years.
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 a form to acknowledge they are aware that funds are being borrowed against a retirement account. At Self Directed Retirement Plans our prototype 401 k plans include the appropriate loan forms.
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. There are no taxes on interest paid back into the account until retirement age. Taxes are not due until funds are actually distributed
The Cons of Borrowing from a 401k
- Opportunity cost: Removing money from a retirement account diminishes its’ ability to earn interest (greater than the interest you are paying) from external sources until it is returned to the account.
- Reduced Contributions: Loan re-payments go back to your own 401k account so unless your income and contributions have increased, the borrower is likely making smaller contributions to the plan because income is tied up in a loan re-payment.
- 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 59 ½, there is an additional 10% early withdrawal penalty.
- Unexpected loan default: If a self-employed borrower 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.
Once the decision is made to take a loan from your qualified plan, simply complete the loan forms.
Once the forms are completed, make and keep a copy for tax and personal finance records. Always make sure to keep these records in case 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. Simply write yourself a check from your 401k checking account for the 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 www.sdretirementplans.com or you can call us at 1-866-639-0066.
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Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He brings over 30 years of diverse experience as a financial advisor. Rick takes great pride in giving honest and very experienced advice. Rick can readily converse with business owners and people looking to take control of their retirement accounts.