In this article we will review the rules for issuing a loan from your self directed 401k to yourself. You can take a loan from your self directed 401k for almost any reason but you need to be careful to stay within the rules for the transaction. If you give the IRS grounds to complain then they can classify the transaction as an early distribution and hit you with the early withdrawal penalty. Also a self directed IRA does not allow loans to yourself, this is only for self directed 401ks.
The first major limit is how much and how long you can borrow. You are limited to the lower of $50,000 or half of the value of your self directed IRA. These limits are per participant so If a married couple uses the same self directed 401k then each can withdraw up to the limit above. You may have up to 3 loans from the 401k at any given time and the total of the loans may not be greater than the limits above. Your loan has a maximum term of 5 years unless the loan is used to purchase a primary residence. The limit for purchasing a primary residence is generally accepted as 15 or 30 years. The rules for this exception are vague and you should consult your 401k custodian or tax adviser if you want to try this type of loan.
Next let’s talk about payments. The interest rate for the loan is generally the certificate of deposit rate + 2% or the prime rate + 1%. I would recommend using the prime rate + 2% to ensure the IRS can’t complain your interest rate was unreasonable. Also you are paying the interest to your own 401k so it’s not like you lose the extra 1%, you just saved a bit more for retirement. Payments must be made on an amortized basis meaning you are paying both principal and interest in regular payments over the life of the loan. You must make at least quarterly payments but there is no penalty for early repayment. The company that helped set up your self directed 401k should have documents to help you set up the loan terms and repayment schedule. The cost of origination and various maintenance fees may be applied and vary depending on the company you’re working with. Some companies do not allow loans from self directed 401ks in their care. If you are in this situation then you could consider transferring your 401k to a different company.
Last and most important we have the penalties for failing to repay your loan. If you fail to make a quarterly repayment you may have a small grace period depending on the loan terms. If you can not make the payment by the end of the grace period then the loan will be deemed a cash distribution from your retirement account. This means you will have to pay income tax on the remaining loan balance and if you are below the age of 59 and a half you will have to pay an additional 10% penalty. On the bright side you don’t have to report this default to the credit unions because it was a deal from you to you. For this same reason you don’t need to pass a credit check to get the loan.
As always it is of the utmost importance to discuss changes to your retirement account with a tax advisor or retirement advisor. The penalties for a misstep can be severe so taking a bit of time to plan out your actions is always worth it. I hope you have found this helpful and feel free to contact me for any questions.
Have a great day.