Does a Promissory Note NEED an Interest Rate?
If you’re considering a promissory note investment inside your Solo 401k or self-directed IRA, one question comes up again and again: does the note actually need to charge interest? This guide answers that question directly — and covers everything else you need to know about structuring a compliant promissory note, setting a fair interest rate, avoiding usury law violations, and staying clear of prohibited transactions.
Watch: My Solo 401k Financial explains why a promissory note must always charge a fair interest rate
The Short Answer: Yes, a Promissory Note Must Charge Interest
Promissory notes are one of the most common ways to document a private investment — also known as a private loan — where a Solo 401k makes an investment in a third party. Whether the promissory note investment is made through a self-directed Solo 401k or a self-directed IRA, the answer to “does a promissory note need an interest rate?” is a clear yes.
⚠️ The Interest Rate Cannot Be Zero
The interest rate listed on a promissory note cannot be zero. If you invest in a promissory note and charge zero interest, that investment is not going to benefit the Solo 401k plan — and benefiting the plan is the entire point of making the investment in the first place.
Why the Plan Must Benefit from Every Investment
Anytime you invest Solo 401k funds — whether in equities, real estate, or promissory notes — it has to be done with the intention of growing the retirement plan. Congress created retirement plans, including Solo 401k plans, specifically so individuals could save for retirement. If you don’t charge a fair interest rate that benefits the plan, the plan simply won’t grow, defeating the entire purpose of the investment.
ℹ️ The Plan Must Benefit — Not the Borrower
A promissory note investment should be made with the intent of growing the Solo 401k plan — not necessarily to help the borrower. Of course, the borrower is helped indirectly by being able to access financing. But the interest rate charged needs to reflect what return the Solo 401k will earn — not be set artificially low as a favor to the borrower.
What Exactly Is a Promissory Note?
A promissory note is a promise by a borrower to repay money to a lender — in this case, the lender is the Solo 401k plan. It is a written instrument that acts as evidence of the investment and outlines the payment terms.
Required Elements of a Promissory Note
The promissory note must be drafted accordingly and include all of the following pertinent information:
💡 Sample Promissory Note Available
My Solo 401k Financial provides a sample promissory note on the Forms tab of their website that you can use as a starting point when drafting your own note. As the trustee of the plan, you’ll also want to sign the promissory note and put together a clear payment schedule outlining the amount of each payment and when it’s due.
Don’t Confuse a Promissory Note Investment with a Participant Loan
It’s important not to confuse a promissory note investment with a Solo 401k participant loan. They are entirely different concepts:
How Do You Determine the Right Interest Rate?
You typically want to charge an interest rate based on the borrower’s credit history. If the borrower has good credit, the interest rate should generally be lower than for a borrower with poor credit — because the odds of the note going into default increase as creditworthiness decreases.
Factors to Consider When Setting an Interest Rate
💡 Typical Interest Rate Range
A typical interest rate charged on a promissory note generally falls between 8% and 15% — especially for unsecured notes. This range has even been seen applied to secured promissory notes in some cases. As always, a reasonable rate depends on the specific facts and circumstances of each individual loan.
Don’t Break Usury Laws — There’s a Ceiling Too
While the interest rate cannot be zero, it also cannot be set too high. You need to make sure you don’t break any usury laws, which are driven by your state of residence.
⚠️ Charging Too Much Interest Can Also Be a Problem
If you charge, for example, a 20% interest rate on a promissory note to an individual or business with good credit, state usury laws could come into play and flag that rate as excessive. The interest rate must be reasonable in light of the borrower’s risk profile — charging an unreasonably high rate just because you can isn’t a safe approach, and it can run afoul of your state’s usury limit.
How Must the Funds Flow? Critical Compliance Rules
Once you’ve documented the promissory note investment in writing, the funds need to be wired directly from the Solo 401k holding account to the borrower. This is a critical compliance point that My Solo 401k Financial emphasizes repeatedly.
⚠️ Funds Cannot Pass Through Your Personal or Business Account
It cannot be wired first to your business or personal bank account on the way to the borrower. If that happens, it will be treated as a taxable distribution — even if the funds eventually reach the borrower as intended. The flow of funds must go directly to the borrower’s bank account, with no detour through your own accounts.
ℹ️ Receiving Payments by Check
If the borrower makes a payment by check, they can mail the check made payable in the name of the Solo 401k, addressed to you as trustee. You then deposit those funds into the Solo 401k bank or brokerage account. As long as the payments flow directly to the Solo 401k holding account, they maintain their tax-deferred status — growing tax-deferred so you can reinvest those funds within the plan.
Can You Lend to a Family Member? Disqualified Person Rules
This is a special area of concern under the prohibited transaction regulations. You cannot invest in a promissory note to a family member — even if the Solo 401k plan receives a favorable interest rate and the note is fully and properly documented.
Who Is a Disqualified Person?
⚠️ Even Helping Your Child Buy a Home Doesn’t Qualify
A Solo 401k cannot invest in a promissory note to your child — even at a market interest rate, even if fully documented, and even if your intention is simply to help your child with their first home purchase. Unfortunately, this type of transaction is not allowed and would constitute a prohibited transaction.
💡 Lending to an Unrelated Friend’s Business Is Allowed
By contrast, a Solo 401k can invest in a promissory note to an unrelated friend’s business. For example, if a friend has a business and approaches you for financing, you can invest your Solo 401k funds in a promissory note to that friend’s business — as long as you are not an employee or owner of that business. You’ll still want to document the note properly and charge an interest rate that benefits the plan.
How Can a Promissory Note Be Structured?
A Solo 401k promissory note can be structured in different ways, and you get to decide what works best for your situation:
You can also decide how often payments are made — monthly, quarterly, or annually — and that schedule needs to be clearly outlined on the promissory note itself.
💡 Example: A Properly Structured Promissory Note
Suppose a Solo 401k plan invests in a promissory note worth $100,000 to an unrelated party. The note lists the principal amount of $100,000, along with the agreed-upon interest rate. The funds flow from the Solo 401k bank or brokerage account directly to the borrower, and the borrower then makes payments directly back to the Solo 401k plan. This type of structure is very common because the Solo 401k receives a stated, predictable return and all loan terms are clearly documented in writing.
Key Takeaways: Promissory Notes and Interest Rates
Ready to Structure Your Solo 401k Promissory Note Correctly?
Whether you need a sample promissory note template, guidance on setting a compliant interest rate, or help opening a self-directed Solo 401k that allows promissory note investments, My Solo 401k Financial is here to help.
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