Most of us understand the benefits of a solo 401k and that it can be a great tool for the self-employed. But most folks don’t understand the nuances of plan design. That is, how a plan can be designed from the outset to achieve the goals of the plan participant. For example, using a solo 401k to buy a primary residence can be done. But we need to carefully understand the rules.
First of all, most people don’t think that you can use your 401k to buy a primary residence for yourself. This is technically correct. In fact, the 401k is not allowed to have such a related party transaction as it is called a “prohibited transaction“. However, there is a specific loophole that revolves around 401k loan provisions.
But before we take a look at this tax loophole, let’s try to understand how 401k loans work. A solo 401k plan may provide participant loans, but only if it is specifically allowed in the adoption agreement.
Solo 401k to Buy a Primary Residence
Assuming there is a loan provision, the maximum loan amount permitted under the law is: (1) the greater of $10,000 or 50% of the vested account balance; or (2) $50,000, whichever is less. So now that we understand the rules surrounding 401k loans, let’s take a closer look at this strategy.
The plan document requires a loan to have a reasonable interest rate. The payback term can be no longer than five years. However, if the 401k allows for it, there is a specific carve-out that can be included into an IRS approved plan.
This carve-out can allow a longer payback period as long as it is used for a primary mortgage. So instead of a five-year loan you could have, for example, a 15 year loan. This gives the plan participant significant flexibility.
So let’s take a look at an example of how you could utilize this 401k loan provision for a primary residence. Assume you have $100,000 in your solo 401k. Let’s also assume that the plan allows for a loan provision and a 15 year term on a primary residence purchase.
Let’s Look at an Example
Assume you are going to acquire a home for $250,000 and you need a 20% down payment, or $50,000. Because your 401k allows for up to 50% borrowing you can borrow the $50,000 from the 401k. These funds are then used for the down payment on the house. So effectively this is a no money down deal.
The home purchase will not require any of your own cash. You then need to make payments back to the solo 401k at least on a quarterly basis. Any reasonable interest rate on the loan would probably be close to the rate of the new home loan.
This situation may not work for everybody. But it can be a real home run for the right person. If someone needs to acquire a primary residence or even a rental property and has limited capital borrowing, using a loan from your 401k might be a great option. It certainly would be better than pulling money out of the 401k and being subject to taxes along with a 10% penalty.