Solo 401(k) plans are robust retirement plans that are beneficial for the self-employed, including freelancers, and small business owners. Maintaining a retirement plan for yourself and your business can be challenging, but the Solo 401(k) comes with easy administration and low maintenance costs. A great advantage of the plan is the Solo 401(k) loan feature, which allows plan participants to borrow money and use for any purpose.
Borrowing from your Solo 401(k) is just one of the many great features the plan has to offer. It can also be highly advantageous for business owners in need of additional funding for their business.
With an IRA, if you borrow even one dollar from the account, you will be hit with taxes and penalties. However, plan participants can borrow up to $50,000 or 50% of their retirement funds (whichever is less) with a Solo 401(k). For example, if you have $20,000 in your plan, you can borrow $10,000, and the loan comes with a low interest rate. You have to pay the prime rate as defined by the Wall Street Journal, which is 3.50% as of April 1, 2022.
You Can Borrow from Your Solo 401(k) – But There Are Cautions
Borrowing money should never be taken lightly, even if you are borrowing from yourself. Repaymnent of the Solo 401(k) loan is mandatory. If you do not return the funds into your Solo 401(k) account within the specified timeframe (five years), it will be treated as an early withdrawal. As a result, you will incur taxes and perhaps penalties. Here are just a few reasons why you should not borrow from your Solo 401(k):
Loss of Investment
If your plan is earning high income and gains from an investment, you will not receive the compounding power that comes with the investment. So, if the investment returns are high, it is wise not to borrow from your Solo 401(k) unless you absolutely need the funds.
You’re Taking From Your Future
When you remove funds from your retirement plan, you are investing less towards your future. The Solo 401(k) loan can be a beneficial feature, but borrowing from your plan takes away its power of saving for the future.
Can You Repay the Loan?
Before you borrow funds from your Solo 401(k), make sure you are financially equipped to repay the loan during the five-year schedule. The amortization schedule is shorter than many other loans, but the interest rate is low. However, what funds you cannot pay back is treated as an early withdrawal. Again, that comes with all the taxes and penalties of withdrawing funds early.
When Using a Loan to Pay off Debt
If you are planning to use the Solo 401(k) loan to pay off another loan, such as student debt or credit card debt, you should first compare the interest rate of the loan with the returns you currently yield from the investment.
Being able to borrow from your Solo 401(k) is a good plan feature, as it can help individuals fund their business or benefit them during financial difficulty. But keep in mind, you are removing funds that were designed to be used during your retirement. As a result, utilizing the Solo 401(k) loan should be viewed as a last resort.