Who said you can’t have your cake and eat it too?
by Edi Alvarez, CFP
Self employed small business owners have an opportunity to not only save maximally through retirement plans but also build a safety-net through their ability to borrow from their individual 401K accounts. Properly structured they can borrow from their retirement plan when the need arises without incurring the usual 10% penalty for early withdrawal.
In addition, 401k Loans for the Self employed business owners provides a loan, while allowing them to pay back interest to their own 401K rather than a financial institution.
An Individual 401k loan is permitted using the accumulated balance of the Individual 401k as collateral for the loan. Individual 401k loans are permitted up to 1/2 of the total balance of the 401k (but not exceed $50,000). A loan from an Individual 401k is received tax free and penalty free. There are no penalties or taxes if loan payments are paid on time.
Individual 401K Loans
- Can be used for any purpose.
- There are no income or credit qualifications to receive the loan.
- The monthly loan payments of principal and interest are repaid back into your own Individual 401k – you borrow and grow your retirement at the same time.
In addition, the assets can be from prior employer or IRA accounts that are rolled over to your individual 401K account.
Individual 401k are available to self employed individuals and small business owners with no full time employees other than a spouse. Your business can be a Sole proprietorships, LLC, S and C corporations,
The terms are set by the employer (yourself) but the 401k usually has a 5 year maximum repayment term for most loans, except it can be longer, for home purchase. There are no income or credit qualifications although you must charge yourself a competitive interest rate.
Although simple and fast to execute you should remember that you are borrowing on your retirement nest egg. It is only a valid action when you know you will have the ability to pay it back – default results in a withdrawal that can carry a 10% penalty. The loan facilitates borrowing when it might be too difficult or too expensive to go through banks and lending institutions.
As good as it sounds consider that unlike a mortgage or a home-equity loan, if you use a 401(k) loan to buy or improve your home, you won’t get a tax deduction on the interest you pay. You may have to pay a one-time fee to the plan administrator for the cost of originating a loan; the fee is usually $50-100. Your retirement plan will also miss future targets if you don’t continue making annual contributions while you have this outstanding loan. Though most self-employed who borrow from their 401K often pay their loans early it is important not to misuse your hard-earned retirement assets.
As can be seen the 401K Loan, like all tools, has advantages in disadvantages. The advantages for the self employed should encourage anyone who is or is planning to have their own business to begin saving in a tax deferred manner maximally. By using an individual 401K account you can have your tax deferred savings and simultaneously build a safety net.