Participant loans provide an avenue for owner-employees to access their Solo 401k /Individual 401k account balances without incurring tax liability.
Who may borrow money from his or her Solo 401k plan?
Assuming the Solo 401k plan contains loan provisions that allow for participant loans, as My Solo 401k plan document does, as trustee you are permitted to borrow from your Solo 401k. This option became effective beginning January 1, 2002. See [I.R.C. 4975(f)(6)(B)(iii); ERISA 408(d)(2)(C), 29 U.S.C. 1108(d)(2)(C)]
What is a reasonable rate of interest for Solo 401k loans?
As long as theSolo 401k loan interest rate is consistent with the interest rate charged by commercial lenders for a loan made under similar conditions, the interest rate is considered reasonable. See [DOL Reg. 2550.408b-1(e)].
Based on the testimony of a DOL expert, rates considered reasonable by the DOL for loans secured by a participants Solo 401k account balance range from:
- A certificate deposit rate plus 2 percent
- To the prime rate plus 1 percent.
See [Mclaughlin V. Rowley, 698 F. Supp 1333 (N.D. Tex. 1988)]
Must My Solo 401k plan Loan interest rate be reviewed each time a new Solo 401k loan is made?
Yes. The DOL regulations require that the reasonable rate of interest standard must be reviewed at each time a loan is originated, renewed, renegotiated, or modified. See [DOL Reg. 2550.408b-1(a) (3) (ii)]
As such, a Solo 401k plan sponsor cannot simply choose a loan rate at the time the plan is setup and use that rate continuously. Loan rates must be reviewed and updated as often as needed to confirm that they remain uniform with commercial lending practices.
How is My Solo 401k participant loan secured?
Up to 50 percent of the present value of a participants account balance can be used to secure a loan. This is determined at the time the Solo 401k loan is made. See [DOL Reg. 2550.408b-1(f) (2)]
Therefore, if a Solo 401k participant borrows one half of his or her account balance and then takes a Solo 401k hardship distribution before the loan is repaid, he or she will still be in compliance with this rule.
Must the Solo 401k administrator examine the creditworthiness of each Solo 401k borrower?
No. the DOL does not require plan administrators to review financial statements or other indications of creditworthiness of each Solo 401k participant who wants a loan.
Are there any restrictions on how a Solo 401k loan is used by a participant?
No. In fact, as long as the employer does not place any restrictions on use of the loan that would benefit itself, a fiduciary, or other party in interest, there is no reason why a participant cannot independently make the decision to use loan proceeds in a way that would benefit the employer or other restricted party. See [DOL Reg. 2550.408b-1 (a) (4), Ex. 6]
Does the DOL impose any other restrictions on Solo 401k participant loans?
Yes. The parties to a Solo 401k loan agreement must intend to repay the loan [DOL Reg. 2550.408b-1 (a)(3)(i) For this reason, it is important that the plan administrator be diligent in ensuring amounts due on participant loans are timely made.
How may taxation of Solo 401k participant loans be avoided?
The following three conditions must be met in order to avoid taxation of a participant loan at the time the loan is made.
1.The loan must be paid in full within five years, unless the loan is used to acquire a principal residence of the participant. See [I.R.C. 72(p) (2) (B)]
2.The loan must require substantially level amortization of principal and interest, with payments required at least quarterly. For example, a loan for a five-year term that requires payments of interest only until the end of the term, and a balloon payment at the end, does not qualify. [I.R.C. 72(p)(2) (C)
3.The loan is evidenced by a legally enforceable agreement and the loan is limited to a dollar limit equal to the lesser of
(a)$50,000, reduced by: The highest outstanding balance of loans during the one-year period ending on the day before the date a loan is to be made less the outstanding balance of loans on the date the loan is to be made.
(b)The greater of: One half of a participants vested accrued benefit; or $10,000.
See [I.R.C. 72(p) (2) (A)]
Maximum Solo 401k Loan Amount
Generally, the maximum amount that an employee may borrow at any time is one-half the present value of his vested account balance, not to exceed $50,000. The maximum amount, however, is calculated differently if an individual has more than one outstanding loan from the plan.
EXAMPLE: Mark would like to take a loan from his Solo 401k plan. Mark has a vested balance of $50,000, the maximum amount that he can borrow from the account is $25,000.
50% x $50,000 = $25,000
If Mark had a vested balance greater than $100,000, he could only borrow $50,000
What happens if My Solo 401k Loan amount exceeds allowed amount?
If the principal loan amount exceeds allowed amount, the amount of the loan that exceeds the limit will be deemed a distribution and thus taxable to the participant.
Applicable tax reporting if My Solo 401k Loan amount exceeds allowed amount
If a Solo 401k loan is treated as a taxable distribution, it will be subject to a 10 percent early distribution penalty if the employee is under age 591 1/2. 2. See IRC Sec. 72t If a Solo 401k plan loan fails to satisfy the loan regulations and is considered a deemed distribution, code L is to be used on Form 1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., to report the distribution.
DOL & IRS Solo 401k Loan Requirements
- The loan must have level amortization, with payments at least quarterly.
- The loan generally must be repaid within five years.
- The loan must not exceed statutory limits.
- Bear a reasonable rate of interest
- Be adequately secured (DOL Reg. 2550.408b-1(a)(1)).
Solo 401k Loan Repayment Terms
IRC Sec. 72(p)(2)(C) requires that the loan amortization schedule provide for substantially equal payments to be made at least quarterly.
Solo 401k Loan grace period for late payment
Effective January 1, 2002, Treas.Reg.1.72 (p)-1, Q&A 10, provides for a cure period that allows a loan participant to avoid an immediate deemed distribution following a missed payment. The cure period may not extend beyond the last day of the calendar quarter following the calendar quarter in which the required payment was due.
Solo 401k Loan Repayment Period (5 years and greater)
Loans must generally be repaid in full within five years from the date of loan origination (IRC Sec. 72(p)(2)(B)). An exception to the five-year payback rule exists for loans used to purchase a principal residence of the participant. If a participant wants a repayment period longer than five years, plan administrators should obtain a sworn statement from the participant certifying that the loan is to be used to purchase the participants principal place of residence (a principal residence, has the same meaning as the term under IRC Sec. 121).
Solo 401k Proper Loan Documentation
Plan loan documents should contain sufficient information to clearly demonstrate that the loan program is intended to satisfy DOL and IRS regulations.
Solo 401k Loan Agreement
The loan must be confirmed by a legally enforceable agreement (Treas. Reg. 1.72(p)-1, Q&A 3(b). According to regulations, the loan agreement must clearly identify an amount borrowed, a loan term, and a repayment schedule.
Other Suggested Forms
Using the following forms further contribute to a smooth and successful Solo 401k loan program:
Loan application form
Payment authorization form
Reporting Solo 401k Loan Defaults
IRS Form 1099-R
If a Solo 401k loan is defaulted, the loan value at the time of default is taxable and reported to the plan participant and to the IRS on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Distribution code L is used only for defaulted loans when there is no offset of the plan balance as a result of a distribution triggering event under the plan. If an offset occurs, the actual distribution is reported as usual (i.e., according to the age of the participant), code L would not apply. The following example illustrates Form 1099-R reporting on a defaulted loan.
EXAMPLE: John Do has a Solo 401k plan balance consisting of $95,000 in cash and $5,000 of outstanding Solo 401k loan assets for a total account balance of $100,000. John defaults on his outstanding Solo 401k loan which results in a deemed distribution of $5,000. For the year of default, the plan administrator issues a Form 1099-R showing a gross distribution amount of $5,000 in Box 1 and a taxable amount of $5,000 in Box 2a. The distribution code is L for a loan treated as a distribution without a corresponding offset. John’s after-tax basis in the plan is not adjusted. After several years, John terminates his business and requests a distribution of his Solo 401k balance which, at that point, consists of $105,000 in cash and the $5,000 outstanding loan amount for a total plan balance of $110,000. Before distribution, the plan administrator offsets the $5,000 outstanding loan amount against the $5,000 loan receivable, leaving $105,000 as the final plan balance valuation. The plan administrator then issues a Form 1099-R showing a gross distribution of $105,000 in Box 1 and a taxable amount of $105,000 in Box 2a.