Participant Loans

My wife used to work for my company and contributed into our Solo 401k. Can she borrow some of her funds as a loan even though she doesn't work for the company anymore?

Answer:

Yes, the funds may be used for a participant loan. If your spouse is no longer working for the company, she can no longer make contributions to the plan. The loan repayment can be made from a variety of sources (i.e. income, personal savings, another loan, etc).

I currently have one outstanding loan from my Solo 401k. I would like to pay it off and take another one (larger in size). Are there any problems with taking multiple loans in a short period of time?

Answer:

Once the 401k loan is paid off, there is a restriction on the amount of the second loan.  The amount for the second loan is reduced by the highest balance of the first Solo 401k loan in the previous 12 months.

Below is an excerpt from the IRS website regarding multiple 401k loans:

https://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Loans

Jim, a participant in our retirement plan, has requested a second plan loan. Jim’s vested account balance is $80,000. He borrowed $27,000 eight months ago and still owes $18,000 on that loan. How much can he borrow as a second loan? Would it benefit him to repay the first loan before requesting a second loan?

Jim will only be able to take a second loan if your plan’s terms allow it. You’ll find how to determine the maximum amount Jim may borrow in IRC Section 72(p)(2)(A). The law treats the portion of the loan that exceeds the maximum amount as a distribution. Generally, any previously untaxed amount of the distribution is taxable. We’ll use the facts in your question to calculate Jim’s maximum allowable loan balance.

The new loan plus the outstanding balance of all other loans cannot exceed the lesser of:

1. $50,000, reduced by the excess of the highest outstanding balance of all Jim’s loans during the 12-month period ending on the day before the new loan (in this example, $27,000) over the outstanding balance of Jim’s loans from the plan on the date of the new loan (in this example, $18,000), or
2. The greater of $10,000 or 1/2 of Jim’s vested account balance.

Maximum second loan if amount still owed on first loan
Jim’s current loan balance is $18,000. This amount plus the new loan cannot exceed the lesser of:

1. $50,000 – ($27,000 - $18,000) = $41,000, or
2. $80,000 x 1/2 = $40,000

Jim’s total permissible balance is $40,000, of which $18,000 is an existing loan balance. This leaves a new maximum permissible loan amount of $22,000 ($40,000 - $18,000).

Maximum second loan if first loan repaid
Because the law bases Jim’s maximum loan on all of his loans during the 12 months prior to the new loan, there isn’t a significant advantage for Jim to pay off his first loan before requesting a second. If Jim repaid the $18,000 before applying for the second loan, he would be limited to the lesser of:

1. $50,000 – ($27,000 – 0) = $23,000, or
2. $80,000 x 1/2 = $40,000

In this case, the maximum permissible loan amount would be $23,000.

I understand that the loan amount allowed for my Solo 401k is up to 50% of the 401(k) account balance or $50,000 whichever is less.  If my Solo 401(k) owns real estate, does the value of the real estate count as part of the account balance, or is it only based on the cash balance in the account?

Answer:

The value of all assets including real estate is taken into account to calculate the value of the 401(k).  However, the 401(k) loan can only be taken based upon available cash in the account.  

Example

Your plan has $20,000 in liquid cash and owns investment property worth $100,000.  The total plan value is $120,000.  Based on the rules, you can have access up to 50% of the value of the plan or $50,000 whichever is less.  In this case the maximum loan amount would be $50,000.  But you only have $20,000 in cash available, therefore $20,000 would be the maximum amount you could take out as a loan without liquidating your investment property.

Can I rollover funds from a 401k with an outstanding loan?

Answer:

It’s best to check with your existing 401k administrator regarding a few issues here.

The first issue is whether or not your plan allows for in-service distributions. If not, you will not be able to transfer any assets out of the plan unless either the plan or your employment with the company is terminated.

Next, you will want to talk with your administrator about the procedure for repaying the participant loan in full before transferring assets. Your outstanding loan balance will most likely be treated as a taxable distribution if it is not paid before transferring your assets out of the plan.

I just took a loan from my Solo 401k.  How soon do I need to make payments for the loan? Also, I want to set up my repayment to be electronic funds transfer from my personal bank account at one bank directly into my Solo 401(k) Trust account at another bank.  Is this OK?

Answer:

If you chose monthly payments on your Solo 401k loan application, the first loan payment should be made a month after the date on your loan application. If you chose to pay back the loan on a quarterly basis, then payments need to be made every three months from the application date.

Note that your loan documentation must include the amortization schedule. Once the loan is approved, you cannot change the amortization schedule.

For loan repayments, it's a good idea to have your payments directly transferred from your personal bank account into your Solo 401(k) bank account. This will ensure you don’t miss payments in the future.  Late payments can result in tax and penalties becoming due on the loan proceeds.

What are the penalties for late payment on a participant loan?

Answer:

In cases of a default, the loan amount outstanding is considered a premature 401k distribution on which you will owe income tax plus a 10% penalty if you are younger than 59 1/2.

If the plan allows a “cure period,” payments made to bring the loan current before the end of the “cure period” must include all accrued interest as well as principal owed on the “cure date.”

The question relates more to late payments and at what point would the loan be considered in default and subject to the deemed premature distribution.

There would be no “late payment penalty” provided the loan was “cured” in a timely manner.

Here is the part of Internal Revenue Regulations pertaining to this issue:

(a) Timing of deemed distribution. Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)(C) and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a cure period and section 72(p)(2)(C) will not be considered to have been violated if the installment payment is made not later than the end of the cure period, which period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due. (can be approximately 3 months)”

(b) Amount of deemed distribution. The amount of the deemed distribution equals the entire outstanding balance of the loan (including accrued interest) at the time of such failure.

(c) Example. The following example illustrates the rules in paragraphs (a) and (b) and is based upon the assumptions described in the introductory text of this section:

Example. (i) On August 1, 2002, a participant has a nonforfeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over 5 years in level monthly installments due at the end of each month. After making all monthly payments due through July 31, 2003, the participant fails to make the payment due on August 31, 2003 or any other monthly payments due thereafter. The plan administrator allows a three-month cure period.

(ii) As a result of the failure to satisfy the requirement that the loan be repaid in level installments pursuant to section 72(p)(2)(C), the participant has a deemed distribution on November 30, 2003, which is the last day of the three-month cure period for the August 31, 2003 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 2003. Alternatively, if the plan administrator had allowed a cure period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 2003 equal to $17,282, which is the outstanding balance of the loan at December 31, 2003.

How is the amount includible in income as a result of a deemed distribution under section 72(p) required to be reported?

Answer:

The amount includible in income as a result of a deemed distribution under section 72(p) is required to be reported on Form 1099-R (or any other form prescribed by the Commissioner).

Your Solo 401(k) plans state that within 10 days of the first missed payment, the administrator must notify the participant in writing that the loan will be in default if it is not cured by the end of the quarter following the quarter that the first payment was missed.  This is the longest cure period available under these regulations.

Answer:

A Solo 401(k) participant can borrow up to either $50,000 or 50% of their account value (whichever is less) with the following terms:

• To be repaid over an amortization schedule of 5 years or less
• Regular payments no less frequently than quarterly, i.e. monthly or quarterly
• At a reasonable rate of interest, generally interpreted as prime rate + 1%

Under what conditions is this allowed?

Any. As long as the plan documents allow for it and the proper loan documents are prepared and executed, a participant loan can be made for any reason.

How can I obtain the loan documents?

We provide the Solo 401(k) loan documentation on our client portal. Our loan agreement is in compliance with the DOL and IRS requirements that state that 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.

Loan documents include a completed loan agreement and a printed loan amortization schedule.  These must be completed before taking the loan.

When is a participant loan useful?

A Solo 401(k) participant loan can be useful when someone is thinking about distributing money out of their retirement account for some reason. I recently spoke with someone who wanted to distribute $20,000 of of her IRA in order to pay off $10,000 of a high interest credit card debt she accumulated because of a medical emergency.  She had to take out $20,000 because it would have cost her almost $10,000 in taxes in penalties to have additional $20,000 in taxable income.

After we spoke, her strategy was amended to the following:

• Setup a Solo 401k plan (adopted by her business) and transfer IRA funds into it
• Take a participant loan of $10k
• Pay off $10,000 in credit card debt

The result of the new strategy:

• Avoided IRA distribution
• Avoided $10,000 in early distribution taxes and penalties
• Paid participant loan back within couple years

There are many other common uses for a Solo 401(k) participant loan. If a person wants to make a <$50k investment that would otherwise be a prohibited transaction, they can take a participant loan to borrow the money and do the investment as an individual.

The standard limit for a participant loan repayment period is five years or 60 months.

The only exception is for using the loan to purchase a primary residence (real estate).  If the participant loan will be used for the purchase of a primary resident, the loan repayment period can be extended up to 15 years.  In order to qualify for the extended repayment period, the loan must be designated as going towards the purchase of a primary residence property.

Please note that the extended repayment period is not applicable for refinancing and can only be used toward new purchases only.