Taking a Loan versus Distribution
Borrowing money from your self directed IRA is a prohibited transaction and can disqualify the entire IRA. On the other hand, a Self directed 401(k) allows an individual to borrow money for almost any purpose. If you are in a financial crisis, are in need of funds and you have no other option except to tap into your retirement account, it is always wise to take a loan rather than requesting a taxable distribution. Distributions can be a costly affair. In case of early withdrawal, the investor would not only have to pay the income tax, but also incur a penalty (as much as 10%). If you are in the 40% tax bracket, the distribution is likely to cost you about 50% of your fund value. This is really scary and a very expensive way to tap into your own funds.
Purpose for which you can take loan in a self directed 401(k)
A self-directed 401(k) lets you have the liberty of borrowing money when required. There is also no restriction on where you can deploy the loan funds. You can use the loan funds for almost anything such as buying a home, a car and even spend it for a vacation. But remember that you would have to pay the interest and principal out of your post tax money, which might pinch you later. So be careful when you borrow. You are also likely to lose interest / dividends / capital gains on the money that is withdrawn, which you would have otherwise earned. So in nutshell, a loan from a 401(k) has its costs, but is still better than taking a distribution. So while you decide to borrow from your self-directed 401(k), weigh the pros and cons thoroughly.
The cost of a self directed 401k loan
The amount of interest that you would pay on the loan has to be legitimate and commensurate with other loans.
How much you can borrow
The amount a plan participant can borrow has to be lower of $50,000 or one-half of the participant’s plan balance. The loan is available almost hassle free and no credit check will be performed. The reason there is not credit check is: you are just using your own money there is no risk of a moral hazard or harm to any third party. If a husband and wife are both participants of a self directed 410 k plan, each can borrow up to the limits described above.
Repayment of Loan
Remember a 401K loan is still a loan and must be repaid. If you have a regular pay period, then a blended payment consisting of principle and interest will be made according to the amortization table you selected. If you have irregular payment periods, a blended payment must be made every 90 days. The maximum amortization allowed is five years. Any remaining loan balance after five years will be treated as a “deemed” taxable distribution. If you are borrowing for constructing your residence, you may be granted longer repayment tenure.
At Self Directed Retirement Plans, we advise account holders regarding how they can plan a most cost effective loan from their self-directed 401(k) account. We also have all the documents required to properly secure a loan. Although your plan is self directed, you are the responsible person and always want proper documentation if the IRS decided to audit your plan.