Another Reminder – Self-Directed 401K Loans and Options

As much as I have commented on 401K loans, people always keep coming back and inquiring about loans. Now, don’t get me wrong, I think exercising 401K loans are not only a valuable avenue to potentially exercise, but can also make good financial sense. But, the ultimate key to whether or not one should take a loan is based on whether they’re disciplined and able to repay the loan?! If so, then a loan provision can be a valuable tool for you to consider using.

Obviously, in today’s sluggish economy, taking a loan from a 401K is of interest to many, and one of the most “googled” terms when it comes to inquiries about 401K plans. This is both unfortunate and expected. However, a 401K loan (and let’s look within the confines of a self-directed 401K plan), can be a great tool for the able and disciplined individual.

Ease and Access –- When you meet the requirements for a self-directed 401K and have your funds within your own 401K plan, accessing your funds can be:

1) Quick,
2) Easy,
3) Confidential, and
4) No Credit History is taken into consideration?

Loan Requirements -– Obviously, IRS requirements need to be met. If one qualifies for the 401K plan, they can take a loan of up to 50% of the account balance OR $50,000, whichever is less. Further, this loan can be

1) Used for any reason whatsoever and is
2) Tax and Penalty Free as long as they….
follow the IRS’ terms for loan repayment. So, what are the repayment terms? Well, simply, the general parameters are that:

1) The loan must be fully repaid with P & I within 5 years;
2) The loan must be amortized with quarterly repayment terms;
3) Interest must be legitimate (a good example would be in taking the loan is for the individual to always charge themselves at least 1% more than the going rate. However, remember, all loan P & I proceeds are going back to YOUR retirement account.

Now, let’s say that an individual is in desperate need of some of their retirement funds due to financial chaos. This individual is, for this example, self-employed and has all their retirement assets in an IRA (but they, as an individual, qualify for the 401K). Let’s also say that the individual is 45 years old and is in a 40% tax bracket. Due to their need or want, they are thinking about taking a distribution from their IRA. How would they be affected (this is only for illustrative purposes only, ALL tax questions you have should be directed to your CPA or tax preparer) if they took a $50,000 distribution from their IRA?

Distribution Proceeds — $50,000

Less Federal, State and Local Taxes — $20,000

Less 10% Imposed Excise Tax — $5,000

Remaining Funds Free to Individual — $25,000

Yikes, pretty scary. Now, let’s use the same individual who qualified for a Self-Directed 401K and, once established, took a loan from their account. Of course, they still have to meet the requirements for loan repayment previously stated, but now look at how by taking the loan, what happens to the numbers:

Loan Proceeds — $50,000

Less Federal, State and Local Taxes — -0-

Less 10% Imposed Excise Tax — -0-

Remaining Funds Free to Individual — $50,000

Here is where the able and disciplined comes into play.

IF the individual is ABLE to repay the loan and DISCIPLINED to repay the loan, why would the individual ever want to take the money out as a distribution?! First, they are draining their retirement account by $50,000 and only keeping $25,000 of the distribution with the IRA. In contrast, with the 401K, the individual can have full access to the $50,000 and, if able and disciplined, repay all the money back to the plan (therefore, not draining it by $50,000).

Further, by paying interest as well, the individual is also adding money to the plan. In doing the loan, they still have the ability after the loan repayment to keep the $50,000 in their retirement account, add additional monies in loan interest to the plan, utilize 100% of the funds for what they want to use the funds for, and not be penalized with potential Federal, State and Local taxes.

NOTE: All of this “good” news is also tempered by the fact that the individual repays the loan. If an individual does not repay a loan, the unpaid portion is considered taxable income and may be subject to full taxation AND a 10% excise tax (if the individual is under the age of 59½ when the loan was taken).

To loan or not to loan….that is the question (gosh that sounds like a cheesy use of plagiarism)! However, if exercised correctly, the loan from the 401K can be a very advantageous tool for the individual to consider.

In the next post, we will do a quick review of what requirements must be met for an individual to be considered self-employed and qualify for the self-directed 401K….it may not be as difficult or cumbersome as you may think!

This entry was posted in 401(k)'s & IRA's, Financing on by .

About John Park

John Park is a facilitator for self-directed IRAs and 401Ks and founder of PGI Agency, Inc. which is host to PGI SelfDirected. Prior to that, John maintained his own insurance agency and also worked in intercollegiate athletics (Arizona State University, Big Ten Conference Office). For over 6 years, PGI has established both self-directed IRA and 401K accounts so that individuals can take control of their retirement assets and invest in both Traditional and Non-Traditional (e.g., real estate) assets. John believes that most people should fully explore having FULL control of their retirement funds and be the steward of their own money.

5 thoughts on “Another Reminder – Self-Directed 401K Loans and Options

  1. Jesse

    John, this sounds interesting. What are the typical fees for starting and maintaining a self directed IRA. Is there an annual fee? What are transaction costs from moving from one investment vehicle to another within the SDI?

    Reply
  2. Christi Gilhoi

    Timely article. I was just looking into using some retirement funds for my second investment property and weighing the advantages of the pros and cons of distributions vs. loans.

    Reply
  3. John Park

    Jesse, first, any BawldGuy reader receives a discounted fee, but fees can vary based on a few factors. If you would like to discuss so I can narrow it down for you, just let me know.

    Let me explain what PGI does and two potential options you have. First, we set up SD IRAs and 401Ks. So, my first question if I was visiting with you is whether you are strictly a W-2 employee (with no self-employment), retired or self-employed, or a combination of a W-2 and self-employed. If you qualify for a 401K, generally speaking, I would highly recommend that you strongly consider the 401K. With the 401K, there is a one-time fee (only) and no annual fees. In contrast, with the IRA, there is a similar one-time fee, and an annual custodian fee. The lowest annual custodian fee is $105.

    The reason for an annual fee for the IRA and not for the 401K is that it is a Congressional mandate that all IRAs be “held” by a custodian, where with the 401K, and individual can serve as their own Trustee…..you can kind of see now why I like to visit to understand people’s situations as there are different possible situations for different people. Whether you have the 401K or the IRA, PGI establishes the plan so that you have checkbook control of your assets.

    You asked about transaction costs….again, another difference between PGI and maybe some other similar company. PGI establishes your plan so that you have checkbook control of your retirement assets….you may be familiar with other models for SD companies where you “park” your retirement funds with them, they control the checkbook, you have to request funds any time you want them, and then they charge you “transaction” fees on top of that. If you are a PGI client, you will never have any fee other than the one-time fee (401K) and never more than the one-time fee with annual custodian fee (IRA).

    Let me know if you would like to discuss more. PGI provides both an honest and transparent explanation of the SD process (generally) and PGI SelfDirected (specifically) to show you how you will have checkbook control of your retirement assets. If you want to reach me directly, you can reach me at 602.684.2922 or john@pgiselfdirected.com.

    Thanks for the inquiry and best of luck.

    John

    Reply
  4. John Park

    Christi, first, congrats to you for thinking about the possibility of using retirement funds for the purchase of an investment property. Most indivdiuals are not aware that they can potentially use retirement funds (of course following all IRS regulations) for such investments.

    So, we are on the same page with semantics and terms, let me define the difference between the two terms (distribution and loan) that you referenced and actually introduce a third term which is what you most likely will do.

    Loan — With a 401K loan you can take a loan of up to $50,000 or 50% of the account balance, whichever is less. These loan proceeds can be used (and not taxed) for any reason you want as long as you follow IRS regulations with regard to loan repayment, etc. Notice, I said LOAN with a 401K. With an IRA there are NO loan provisions (per se)…you can only take money out for specific reasons, typically related to hardship (not purchasing property as an example). So, when you think of loan, think of 401K. If you took money out of your IRA, it would be a….

    Distribution — With a distribution (either IRA or 401K), any monies you take will be taxed at potentially Federal, State and Local levels but, also, if you take the funds out prior to 59 1/2 you will have a 10% excise tax as well…not fun. To keep things simple, however, let’s use the example if you wanted to take out $50,000 from either an IRA or 401K. With the 401K (if you wanted) you could take out a $50,000 loan (if you qualify, of course) and other than repaying the loan, not having any taxes or penalties. That same transaction within your IRA will result in Federal, State and Local (potentially) taxes and the 10% excise tax (if under 59 1/2). As a result, you may be left with only $25,000 of your original $50,000 distribution.

    What I think you probably meant to say and what you want to do is to do an…..

    Investment — from either your IRA or 401K. If you have a SD IRA or 401K established and have checkbook control of those funds, you will be able to make an investment from either the IRA or 401K for the property. You do not need to take either a loan or a distribution provided you are buying the property for investment purposes and to not trigger an IRS Prohibited Transaction.

    Now, while loans can be very beneficial to you from a 401K, just so we are on the same page, let’s use a hypothetical example and you tell me what is better. Let’s say you were able to purchase a property for $50,000 that you wanted. Would it be better (generally speaking) to purchase it through a LOAN, DISTRIBUTION or INVESTMENT?

    Loan — You would have to repay the loan based on the IRS’ terms for repayment and, honestly, if you are wanting the property as an investment, there is really no reason to do the loan as you can purchase the property as an investment. Without opening up a long conversation, if you said you wanted to buy the property and use it yourself, as an example, then I would definitely recommend the loan…we can talk more about that.

    Distribution — If you take a distribution, you will have heavy taxes and potential penalties. Out of the $50,000, you would most likely walk away with around $25,000….not good in most cases.

    Investment — If you purchase the property out of the IRA or 401K as an investment, now the property and returns will all grow tax deferred (if traditional, pre-tax funds) or tax free (if Roth, after tax funds).

    Sorry for the length of this….I think we are on the same page that you are probably wanting to SD an IRA or 401K to make an investment of property rather than purchasing a property with distributions or loans….but I just wanted to go into a bit more detail.

    If you would like to visit about how PGI sets up these plans so that you can have checkbook control of your retirement assets, just contact me directly at 602.684.2922 or john@pgiselfdirected.

    Have a great day…hope I didn’t ramble too much :)

    John

    Reply
  5. sam

    Hi John,

    Thanks for your informative article. I have a question regarding 401k loans. If you had 2 401ks (one with work and one from a solo side business) and each one had a $100,000 balance, could you take a $50k loan from each. I’ve read the IRS regs but can’t see where it says the $50k is a cumalitive #. Thanks for any light you can shed on this.

    Reply

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