Solo 401k Loan Interest Rate and How to Borrow from Your Solo 401k
The solo 401k is an attractive way to save for retirement for small business owners because it’s relatively cheap and easy to set up. Most people assume, however, that it has the same pitfall as other types of retirement savings accounts; namely that there is no way to access the money before retirement without a hefty penalty.
These same people are often pleasantly surprised to hear that many solo 401k accounts have a loan feature. In plain English, this means you can borrow from the account without penalty or taxes and often at a relatively low interest rate.
What is the Solo 401k Loan Interest Rate?
Almost all solo 401k loans have an interest rate equal to the prime rate plus one point.
The prime rate is the lowest rate at which banks in the US will lend money. The Wall Street Journal is a reliable source for what the current prime rate is. So if the prime rate is 4.75% when you apply for your solo 401k loan, which it is at the time of writing, then your solo 401k loan will likely have an interest rate of 5.75%.
Does Every Solo 401k Allow Loans?
Not all solo 401ks allow loans. It’s something that has to be set up when you open the 401k account. To find out if your solo 401k has a loan provision, call the company or advisor who manages it for you and ask. It should be a simple yes or no answer.
What if My Solo 401k Doesn’t Have a Loan Provision?
If your solo 401k doesn’t allow a loan provision, you can always open up a new solo 401k that does allow loans and roll the money from the old account into the new account.
On a side note, you can also roll money from other retirement types of retirement plans that don’t allow loans like traditional IRAs. Many people who find themselves in a tough spot will roll money from a traditional IRA into a solo 401k so that they can access their retirement money through a loan.
How Much Money Can I Borrow?
The simple answer is that if your solo 401k balance is under $100,000 you can borrow up to half of your account balance. If your solo 401k balance is over $100,000 you can borrow up to $50,000.
So if you have a solo 401k with a balance of $40,000 you can borrow $20,000. And if you have a solo 401k with a balance of $200,000, or $300,000, or $475,000 you can borrow $50,000.
What if I Still Owe on a Previous Solo 401k Loan? How Much Can I Borrow Then?
Things get more complicated if you already have another loan your solo 401k outstanding. Basically, previous loans lower the max amount you are allowed to borrow on subsequent loans. Let’s look at an example to see how this works.
Say Bill has a solo 401k with a vested balance of $90,000. A year ago he took a loan from the account and still needs to pay off $10,000 of that loan. Now he wants to take a second loan out. He calls the financial advisor that oversees his solo 401k and tell her that he wants to take out a second loan for $45,000. She tells him that he can’t do a $45,000 loan. Since his account balance is $90,000 the max amount he is allowed to owe at any given time is $45,000. If you add the outstanding amount from the first loan ($10,000) to the new loan he’s requested ($45,000) you get $55,000 which is a full $10,000 over his max. So he’d have to take out a loan for $35,000 or less.
Most financial advisors and financial planners can easily tell you how much money you can borrow from your solo 401k account by looking at your account balance and any previous loans you still owe on.
When Can I Take the Loan?
You can take a loan from your solo 401k as soon as the account is funded. There is no waiting period or restrictions on when you can take loans.
What I Can Use the Money For?
There are also no restrictions for what you can use the money for. The money can be used for any purpose you deem worthy.
Will I be Taxed on the Loan Disbursement?
No. You won’t be taxed. You will be taxed on regular distributions you take from the account once you’re retired, but you aren’t taxed on any loan disbursements.
When Do I Have to Pay Back the Loan?
Most solo 401k loans are scheduled to be paid back over a period of 5 years. When you take out the loan, the company that manages your solo 401k will lay out a repayment schedule. Payments are usually made monthly or quarterly and will start immediately after you receive the loan money.
As with any loan, there are consequences if you fail to make your payments. Usually, if you haven’t paid back the loan by the end of your payback period, the unpaid balance of the loan will be treated like a withdrawal. And if you are under 59% this means you’ll get hit with an early withdrawal penalty as well as taxes.
Can I Pay the Loan Back Early?
Yes. If you happen to come across a windfall and want to pay the loan off early you are usually permitted to do that.
Are There Any Reasons I Should Not Take a Loan from my Solo 401k?
The ability to borrow from a solo 401k can be a real life saver for people in situations where they need a quick source of cash. This doesn’t mean there aren’t downfalls to taking this kind of loan, however.
Other than issues that might come up if you can’t pay the loan back, the biggest problem with solo 401k loans is that you will lose any growth the money would have made by staying in the account. Say you took a $10,000 loan out to make a down payment on a car and it takes you five years to pay that amount back to your solo 401k. And say during those five years that your investments in the account grew at a rate of 4%. In this case, you just lost out on about $2,000 of investment growth.
So I Can Borrow from my Solo 401k, but it Should be a Last Resort?
As with so many things in life, just because you can borrow from your solo 401k doesn’t mean you should.
It can be very tempting for people in a bind to look at their retirement savings and think they can fix everything by taking out a little loan. It’s important, however, to step back and look at the big picture. Is there any other way you can pay for what you need? Are you aware of the possible loss of investment growth taking a solo 401k loan could mean?
There are no easy answers when you find yourself in a situation where you’re thinking of borrowing from your retirement savings. But it is possible that with some level-headed thinking you can make an informed and calculated decision.
Okay, I’m Ready to Take Out a Solo 401k Loan.
Thinking of borrowing from your solo 401k or rolling your IRA money into a solo 401k so you can do so? The first step is to talk it through with a professional. Get in touch with your financial planner or advisor and have a conversation about your options.
If you don’t have a financial planner or advisor, it might be time to talk to one. Vector Financial Solutions is a good place to start if you’re in this situation. Vector Financial is located in north San Diego County and has helped many clients and friends navigate the prospect of borrowing from their solo 401ks. They provide free phone consultations to help get you on the right track.
Call 760-741-3159 or click the contact button below to start your conversation with Dave Wilson, certified financial planner at Vector Financial Solutions and author of the Financial Truths blog.
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David Wilson, writer at Financial Truths, is also a financial advisor and Certified Financial Planner® at Vector Financial Solutions, Inc. Vector Financial Solutions is located at 139 E. 3rd Ave., Escondido, CA 92025 and by phone at 760-741-3159.