What makes a solo 401k so versatile and appealing is that it allows for both solo participant 401k loans and promissory note investments. However, these two features are often confused. Here is how to understand both.
Solo 401k Participant Loan: A solo 401k participant loan is similar to a loan from a bank; however, the funds come from the solo 401k owner’s own solo 401k plan–that is, the solo 401k owner/participant borrows from her own solo 401k plan.
Solo 401k Promissory Note Investment: Whereas a solo 401k promissory note investment is just what it sounds like—it is an investment made under the solo 401k but to a third-party, not to the solo 401k owner or her business as the solo 401k rules do not allow for it.
Solo 401k Participant Loan: A solo 401k participant loan is relatively easy to access. For example, a credit check is not required because the solo 401k owner is borrowing form her own solo 401k plan.
Solo 401k Promissory Note Investment: A promissory note investment is also not subject to a credit check; however, it may be in the best interest of the solo 401k owner to have credit check performed on the borrower from a due diligence perspective. This is one way to help mitigate a bad investment by the solo 401k plan.
Solo 401k Participant Loan: The interest rate available on a solo 401k participant loan if often more favorable then a credit card rate especially if the solo 401k owner has bad credit. The interest rate on a solo 401k participant loan is generally the prime rate plus one point.
Solo 401k Promissory Note Investment: The interest rate on a solo 401k promissory note investment is generally based on the borrower’s credit history but it is not required. The rule of thumb is that note investment is made with the intent of the solo 401k benefiting from the investment.
Solo 401k Participant Loan: Under a solo 401k participant loan, if the solo 401k owner does not keep up with the payment schedule and results in loan default, the remaining balance will be deemed a solo 401k distribution. This will result in federal taxes, and depending on the state, stat taxes as well. The 10% early distribution penalty also applies if the solo 401k owner is under age 59 ½.
Solo 401k Promissory Note Investment:If the borrower defaults on making the note payments, the solo 401k will take over the property securing the promissory note if the note is secured by real estate. If it is an unsecured promissory note and the borrower defaults in making the note payments, the solo 401k loses the investment.
Solo 401k Participant Loan: In general, there are three conditions that must be met in order for the loan to remain a plan asset and avoid becoming taxable.
- The loan balance is repaid within five years (an exception exists for loans used to aid in the purchase of a principal residence). The requirement that a plan loan be repaid within five years does not apply to a loan used to acquire a principal residence. The repayment terms increase to 15 or 30 years if funds are used to purchase a primary residence. In general, refinancing cannot qualify as a principal residence plan loan. The other requirements for plan loans still apply.
- The loan must be repaid using a substantially equal level of amortization with payments no less frequently than quarterly. In other words, if you took a $5,000 loan (ignoring interest) from your plan and were paying it back quarterly over five years, each payment should be $250. You could not make 19 quarterly payments of $100 and then one final payment of $3,100 in the last quarter.
- The loan balance also may not exceed certain limits. It must be the lesser of:
- $50,000 (reduced if applicable, by the highest outstanding loan balance from the year prior to, and day of, a new loan)
- The greater of $10,000 or ½ the vested account balance.
Compliance Note 1:
Solo 401k participant loans are not available from IRAs, including SEP and SIMPLE IRAs, but promissory note investments are allowed.