In Part 2 we will address repayment and tax considerations. See Part 1 for general information about solo 401(k) loans.
How to avoid the taxation of solo 401(k) participant loans.
The following three conditions must be met in order to avoid taxation of a participant loan at the time the loan is made.
The loan must be paid in full within five years, unless the loan is used to acquire the participant’s primary residence.
The loan must require substantially level amortization of principal and interest, with payments required at least quarterly. For example, a loan for a five-year term that requires payments of interest only until the end of the term, and a balloon payment at the end, does not qualify.
The loan is evidenced by a legally enforceable agreement and the loan does not exceed 50% of the balance in the account or $50,000, whichever is less. If there is more than one loan outstanding, then all loans, combined, may not exceed the 50%/$50,000 limit.
What if my solo 401(k) loan(s) exceeds the allowed amount?
If the principal loan amount exceeds the limit, the amount that exceeds the limit will be deemed a distribution and thus taxable to the participant.
If a solo 401(k) loan becomes a taxable distribution, it will be subject to a 10 percent early distribution penalty, if the participant is under age 59 1/2. If a solo 401(k) plan loan fails to satisfy the loan regulations and is considered a deemed distribution, code L is to be used on Form 1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., to report the distribution.
Solo 401(k) Loan Repayment Period (5 years and greater)
Loans must generally be repaid in full within five years from the date of loan origination. An exception to the five-year payback rule exists for loans used to purchase a principal residence of the participant. If a participant wants a repayment period longer than five years, plan administrators should obtain a sworn statement from the participant certifying that the loan is to be used to purchase the participants principal place of residence (a principal residence, has the same meaning as the term under IRC Sec. 121).
Solo 401(k) loan grace period for late payment
Effective January 1, 2002, Treas.Reg.1.72 (p)-1, Q&A 10, provides for a cure period that allows a loan participant to avoid an immediate deemed distribution following a missed payment. The cure period may not extend beyond the last day of the calendar quarter following the calendar quarter in which the required payment was due.
Reporting Solo 401(k) Loan Defaults | IRS Form 1099-R
If a solo 401(k) loan is defaulted, the loan value at the time of default is taxable and reported to the plan participant and to the IRS on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Distribution code L is used only for defaulted loans when there is no offset of the plan balance as a result of a distribution triggering event under the plan. If an offset occurs, the actual distribution is reported as usual (i.e., according to the age of the participant), code L would not apply. The following example illustrates Form 1099-R reporting on a defaulted loan.
Solo 401(k) Proper Loan Documentation
Plan loan documents should contain sufficient information to clearly demonstrate that the loan program is intended to satisfy DOL and IRS regulations.
Solo 401(k) Loan Agreement
The loan must be confirmed by a legally enforceable agreement. According to regulations, the loan agreement must clearly identify an amount borrowed, a loan term, and a repayment schedule.
Other Suggested Forms
Using the following forms further contribute to a smooth and successful solo 401(k) loan program:
Loan application form Payment authorization form