Borrowing From Your Solo 401(k)? Be Cautious

Investing
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By Dmitriy Fomichenko

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Solo 401(k) plans are versatile retirement plans, especially useful for small-business owners and independent contractors thanks to their low fees and ease of customization. Another attractive feature of Solo 401(k) plans is a loan option, which allows the plan owner to borrow money at a low interest rate.

Such a loan can be a nice advantage, especially when an influx of cash is needed due to financial difficulty. However, plan owners should be cautious.

The Solo 401(k) loan option, which is not available with an IRA, allows you to borrow from your own retirement funds, up to 50% of the plan value or $50,000, whichever is less. The interest rate is low, at prime rate plus 1%. This can be a great help in case of financial problems. Some people also use these loans to pay off personal debt, moving that debt to a lower interest rate.

Before borrowing from your Solo 401(k), though, consider the loss of investment opportunities it represents. If the plan is earning high investment returns, perhaps it is not wise to take money out of it unless completely necessary.

If you’re thinking about borrowing to pay back other debt, such as student loan or credit card debt, compare the interest rate you’re currently paying with the returns your investments in the plan are earning.

Also consider your ability to repay the loan. While the interest rate is low, there is a five-year payback period, which is shorter than with many regular debts. As a result, each payment will be higher because of the shorter period.

If you can’t pay off the loan within the five-year period, the unpaid portion will be treated as a withdrawal. For those who are younger than 59½ years old, there will be an expensive fine for early withdrawals, on top of the income tax you’ll have to pay.

A Solo 401(k) loan can be useful during financial difficulty, and it can provide a way to move debt to a lower interest rate. However, it should be seen as the last option, because taking money out of retirement savings and away from investments is generally not recommended. As with many other financial tools, Solo 401(k) plan owners need to understand their options before making their decision.