Solo 401k Lon Option vs. Solo 401k Promissory Note Loan

QUESTIONS: Can you please check on the 2 different options for loans of the Solo 401k?
 

First, promissory note to a 3rd party company in which I am an independent contractor;
 

second, a personal solo 401k loan.

Thank you !
 

K. F. From Colorado

ANSWERS: 

Solo 401k Investment vs. Solo 401k Loan

First, a promissory note or loan to a third party including a third party company falls under the solo 401k investment category. So, for example, instead of investing the solo 401k plan in a mutual fund, it can be invested in a promissory note or loan to a third party or company.

On the other hand, a solo 401k plan loan differs from a promissory note investment in that the trustee/participant of the Solo 401k borrows from his or her own solo 401k through a solo 401k participant loan. Therefore, it is not treated as investment but rather a personal loan from the solo 401k that is repaid to the solo 401k by the trustee/participant.

Investing Solo 401k through a Promissory Note to a Third Party

A solo 401k promissory note investment to a third party, whether to an individual or a company, qualifies as an investment provided the solo 401k prohibited transaction rules are not violated.  

 Found in IRC 4975 and ERISA 406, a promissory note investment by a solo 401k to a third party is not prohibited if the following conditions are satisfied:

The solo 401k trustee/participant does not receive a personal benefit (e.g., a commission) from the Solo 401k plan’s investment (In your case, you may not receive a commission based on the fact that you would loan your solo 401k funds in the form of a promissory note to the third-party company.)

The Solo 401k trustee/participant does not gain access to the use of the 3^rd party’s facilities as a kickback for the solo 401k promissory note.  For example, if the Solo 401k promissory note investment was to a golf country club and in turn you used their facilities as a result of the loan, this would be a prohibited transaction because as the trustee of the solo 401k plan you would be personally benefiting from the investment. 

The 3^rd party that you are lending the solo 401k funds cannot be performing services for your solo 401k. For example, you cannot lend your Solo 401k funds to your solo 401k provider because the solo 401k provider performs services for the solo 401k plan.

As the solo 401k trustee you cannot own a 50% or more equity interest of the 3^rd party company.

As the Solo 401k trustee you cannot be an officer, director (or individual having powers or responsibilities to those of officers or directors), or a highly compensated employee.

If the promissory note is to an individual, the following as considered disqualified persons with respect to the solo 401k; therefore, it would be prohibited to process a solo 401k promissory note investment to the following individuals.

Solo 401k Disqualified Persons: You, your spouse, your natural parents and/or adoptive parents, your natural grandparents, your natural children, and fiduciary or service provider of your solo 401k.

Solo 401k Participant Loan

As detailed above, under a solo 401k loan, where the solo 401k plan participant/trustee borrows from his or her own solo 401k, the following rules apply:

• The solo 401k loan must be paid back over 5 years, or 15 years if the funds are used towards the purchase of the solo 401k participant’s primary residence/ dwelling.

• You can borrow 50% of the solo 401k balance up to a maximum of $50,000.

• The solo 401k loan payments are fixed made either quarterly or monthly which is determined at the time of the loan and cannot be later changed.

• Payments consist of principal and interest.

• The interest rate is based on the prime rate plus 1 point at the time of the solo 401k loan.

• The solo 401k provider where you open a solo 401k will need to document the solo 401k loan. The Solo 401k loan must be documented in accordance with the prescribed IRS Solo 401k loan rules.