Updated: Apr 23, 2021
How to avoid the taxation of a loan from a Self-Directed Solo 401(k)? If it becomes taxable, how is it treated and how is it reported to the IRS?
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These three conditions must be met in order to avoid taxation of a Self-Directed Solo 401(k) loan:
1. The loan must be repaid in full within five years, unless it is used to purchase a personal, and primary, residence. In that case, the repayment period is generally 15 years.
2. The loan must be repaid with substantially level amortized payments consisting of principle and interest and are required to be made at least quarterly. Interest-only loan repayments with a balloon payment at the end, does not qualify, for example.
3. The loan must be documented by a legally enforceable agreement, such as a promissory note, and the loan amount must be limited to the lesser of $50,000 (a) or 50% of the account value (b):
(a) $50,000, reduced by: The highest outstanding balance of loans during the one-year period ending on the day before the date a loan is to be made less the outstanding balance of loans on the date the loan is to be made.
(b) The greater of: One half of a participants vested accrued benefit; or the specified minimum amount listed in the plan documents.
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Taxation and Reporting:
If the loan exceeds the limit, the excess amount will be a deemed distribution and is taxable to the individual. The excess is treated as a taxable distribution, and it will be subject to the 10 percent early distribution penalty if the person is less than 59 ½ years of age. To report the deemed distribution on Form 1099-R, complete the appropriate boxes, including boxes 1 and 2a, and enter Code L in box 7.
Source and Additional Resource - Refer to page 8 of IRS Publication: 2020 Instructions for Forms 1099-R and 5498 https://www.irs.gov/pub/irs-prior/i1099r--2020.pdf