Since the new Solo 401k rules were introduced, more people are looking at Solo 401k and its benefits for self-employed individuals. One of the biggest benefits is Solo 401k loan options, which allows account holders to take out up to $50,000 or 50% of the balance at one time, whichever is higher. This could be a great help in time of need, and also a great way to invest with leverage.
Solo 401k rules specifically stated that all recourse financing are listed under prohibited transactions. Therefore, uneducated account holders often shy away from using this great leverage tool, fearing that they would violate the tax law. Understanding the rules is crucial to make sure that you can make the most of your retirement plan without subjecting to any penalty or tax.
What is a Recourse Loan?
A recourse loan is an unsecured loan that is not backed by any collateral. If the borrower fails to repay the loan, the lender can go after the borrower’s assets and pursue legal action against the borrower. With recourse loans, the loan is taken out based on the person’s credit and hence could be seen as for his benefits. Since the account holder themselves is a non-qualified person, the loan has to qualify on its own, without being backed up by the holder.
What is a Nonrecourse Loan?
So how would a lender approve a Solo 401k loan without any back up from the borrowers’ credit? That’s when a nonrecourse loan comes in the picture. A nonrecourse loan is one that requires collateral. With this, the borrower is not liable and the lender can only go after the collateral in case of non payment. That is why a nonrecourse loan is a qualified loan, because in case of default, the lenders cannot go after the fund or the borrowers for payment.
Because of the collateral requirement, nonrecourse loans are most typically used for real estate purchase, where the purchased property will become the collateral. This wouldn’t be helpful with a traditional retirement plans, as they often allow only investments in stocks and mutual funds. Luckily, an individual 401 k plan also allows a wide variety of investments, including real estate, which makes it possible to leverage the investments with a nonrecourse loan.
Interested in leveraged investments? Now it’s time to do your homework. Not all lenders offer nonrecourse loans, so make sure you do some research and find the right lenders to avoid triggering a prohibited transaction.