401 (k) retirement plans, which include most Solo 401(k) plans, allow account owners to borrow up to $50,000 from their account. This personal loan offers the account owner a versatile line of credit, including cash to invest in other opportunities that may not otherwise be accessible within the plan itself. Given the flexibility, 401 (k) loans can be an enterprising way to grow and diversify your retirement account balance. In this article, we will discuss why and when a saver may want to consider a 401 (k) loan.
First, let’s review the IRS rules for 401 (k) personal loans:
- The maximum loan duration is 5 years – one exception to this term exists when the funds are used for the purchase of the account owner’s “primary” residence. In this instance, the plan documents may allow for the loan duration to be extended.
- Maximum loan amount of $50,000 OR ½ of the overall plan value, whichever is greater
- Loan principal payments are required. In loan parlance, the loan must be “fully amortized,” meaning NO interest only loans. Further, the loan must be repaid in equal installments, including both principal and interest.
- “Reasonable” interest rate is required. Lenders and debtors (you in both cases) cannot charge 0% nor unusually high interest rate loans.
- Minimum of quarterly loan payments. Loan payments need to be made at least quarterly, though they can be more frequent.
Now that we’ve covered the IRS basics, let’s look at some of the more common reasons savers take a loan from their 401 (k):
- Personal Reasons: When someone needs cash to pay bills, eliminate debt, or use for other investment purposes, they can take a loan from their 401 (k). There are NO IRS guidelines stating “what” the funds may or may not be used for. As an example, you could use the 401 (k) funds to pay off a car loan. Instead of paying the dealer or bank interest, an individual could pay themselves and grow their 401 (k).
- Purchase of a Primary Residence: When borrowing for the purchase of a primary residence, an individual can borrow up to $50,000 and the loan duration can be longer than 5 years. There are two key aspects to be aware of: 1) the plan documents must have specific language about borrowing for the purchase of a primary residence; and 2) the 401 (k) plan documents determine the maximum length of the loan. Practically speaking, the loan duration could be anywhere from 5 – 30 years. Please note this only applies to a primary residence; you cannot get the extended loan duration for second homes or investment properties (see next).
- Investing Beyond Your Existing 401 (k) Platform Lineup: An investor may wish to use retirement funds to invest in assets beyond their 401 (k) plan sponsor approved platform lineup (eg the typical 10-20 mutual funds). In addition, 401 (k) loans can provide a path to investing in businesses you own. For instance, the IRS does not allow certain investments when retirement funds are involved, such as when an individual is the sole owner. The IRS considers these investments “prohibited transactions,” which may result in a deemed distribution and tax assessment (if not also penalties). Conversely, borrowed money from a 401 (k) is not considered retirement money, and therefore is an acceptable source of funds for these investments. More broadly, 401 (k) loans can be used for direct real estate investing, a popular option here at New Direction Trust Company, as well as virtually any other asset class you may select.
Does your 401 (k) plan offer the personal loan feature? It’s easy to determine – simply contact your plan administrator and ask. For Solo 401 (k) plans such as those offered by New Direction Trust Company, the account owner is often the plan administrator and the personal loan feature is generally established when the plan is created.
The 401 (k) personal loan offers a unique opportunity to access retirement funds without the potential tax implications of distributions. However, account owners must understand IRS rules for borrowing from a 401 (k) plan, and failure to repay the borrowed funds could lead to a distribution and ordinary income tax on the borrowed amount. To learn more, please contact a member of New Direction Trust Company’s business development team to schedule an appointment.