401(k) Loans and Prohibited Transactions

Self-directed IRA and Solo 401(k) plans (also known as Uni-K, self-directed 401(k), self-administered 401(k) and individual 401(k) plans) have strict rules imposed upon the plans to not engage in IRS and DOL Prohibited Transactions.  These rules are specific in their intent and there are significant penalties associated with a plan participating in self-dealing and other types of specifically prohibited transactions.

However, through a 401(k) loan, a plan participant (you) has a potential avenue to execute a transaction that would otherwise be considered a Prohibited Transaction.  There are limitations on this option, but the option exists.

401(k) Participants Loans

Certainly, there are rules governing a participant’s ability to take loans from a plan…and, the key thing to keep in mind is that it is a legally enforceable loan (no raiding the cookie jar whenever you want).  However, it is an option that is potentially available to you IF you comply with the loan requirements.  So, what are these requirements:

  • First, your Solo 401(k) plan documents must permit loan(s) from the plan.  If the plan documents do not permit this provision, the participant cannot take a loan.  It should be noted that most documents will permit loan provisions.
  • Your loan is applied for and executed with a legally-enforceable loan application.  This loan application is made by the participant and approved by the Trustee of the plan.  In a Solo 401(k) plan, it is likely that both individuals will you (the Trustee and participant).
  • Your total loan limit(s) is restricted to $50,000 or 50% of  your account balance, whichever is less;
  • Your loan repayment schedule is 5 years (or less) with an amortized loan schedule;
  • Your loan repayment schedule must be no less frequent than on a quarterly basis (e.g., no paying the loan back semi-annually, annually, balloon payment at the end);
  • Your loan has no pre-payment penalties; and,
  • Your loan interest rate is consistent with current loan interest rates.  At minimum, the loan can be considered to be reasonable if it is the prime rate (at the time the loan is taken out) + 1%.

So, let’s address the simple point.  Yes, the most that you could take out in a loan is $50,000 (and that’s if you qualify for this amount).  With this limitation, you obviously could not take a loan in an amount for more than the total you are able to take out.   However, keep this is mind…

If taken as permitted loan proceeds from the plan, these funds (as a plan participant loan from the plan vs. a Trustee-directed investment from your plan) are now your funds and you are able to use these funds for any purpose.  This is true even if your intended for the use of funds would, otherwise, be considered an IRS Prohibited Transaction (IRC Section 4975).  Remember, remove one limiting thought….a loan is not an investment from the plan, it is a loan to you.  As such, you can use these funds as you see fit provided you comply with IRS regulations governing the securement and repayment of the loan back to the plan.

Let’s use a couple of examples:

1)  Loan Proceeds to Pay Down Credit Card Debt — You have more credit card debt than what you would like to have.  The current debt that you would like to pay off is $20,000.  You have a participant account balance of $150,000 and your Solo 401(k) plan permits loan provisions.  While you qualify for a loan of up to $50,000 (remember, 50% of the account balance or $50,000, whichever is less), you only need to take a loan for $20,000.  You could execute a loan from the plan with an executed, written loan agreement in place, and take the loan proceeds from the plan and pay off this credit card debt.

2)  Loan Proceeds from the Plan to Assist a Disqualified Individual — As the Trustee and participant of your Solo 401(k) plan, you understand that there are certain individuals who are considered disqualified individuals to you and your plan.   A minor child is a disqualified individual.  Your daughter just graduated from college and is “on her own” but needs a bit of financial assistance.  You would like to assist her if possible.

Similar to the first example, let’s assume that you have $150,000 in your plan and your plan permits loan provisions.  You feel no need to take out a loan for the maximum amount permitted ($50,000) as your daughter only needs $10,000 in assistance.  You would like to assist her and you feel that a loan from the plan would be of great assistance.  If done through a loan to you (as participant in the plan), you can now do whatever you wish with the loan proceeds, inclusive of giving the $10,000 to your daughter.  Of course, you are responsible for the repayment of the loan.

Should you take out a loan from the 401(k)?  That is a decision that must be thoughtfully considered.  Remember, relatively easy access to such funds are tempting, but you must keep in mind that there are strict rules related to repayment.  If you do not comply with the repayment terms, the funds are considered to be distributed (meaning taxable) at the moment you fail to comply with the loan’s repayment terms.  So, give serious consideration to your ability to repay the loan.

As always, the information provided is intended to be educational in nature.  It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice.  You must always consult with your respective professional in all such matters.