2

As a quick recap, I'm in the process of doing a gut rehab on my (soon to be) primary residence. I have savings and a line of credit that should cover the full cost, but wanted an alternative source of loan money in the case that things go over budget.

So, thanks to JoeTaxpayer's Suggestion on Creating and Borrowing from a Solo 401K, I'm in the process of setting up an account and moving my IRAs over.

So let's assume I can borrow up to $50K from my 401K. Should I now consider this a superior alternative to the line of credit? In other words, all things being equal, should I exhaust this source of money before I even touch the line of credit?

It seemed counter-intuitive to me at first, but:

  1. Isn't it better to pay myself interest than to pay the bank?
  2. Isn't the risk lower, since the line of credit has a lien on my property, where failure to pay myself back will only result in having to pay taxes and a penalty?

Are there other downsides I'm not seeing?

  • So let's assume I can borrow up to $50K from my 401K. Many solo 401k plans limit loans to the smaller of 50% of the participant's balance or $50K. So, with peanuts of self-employment income and gobs of other IRA/401k money all rolled over into your solo 401k, will you have $100K in your plan? Another downside is that you have to keep reporting peanuts of self-employment income year after year so as maintain the facade of having a business. The IRS can rule that a "business" is actually a hobby which will disallow the 401k plan entirely. – Dilip Sarwate May 29 '14 at 20:04
  • I'm not sure what you mean--I am self-employed. My business is my only source of income. What makes you think that it's side/hobby income? – Phil Sandler May 29 '14 at 20:22
  • If you are self-employed and the business is your only source of income, there is no problem. I think I was attributing something that JoeTaxpayer wrote in the link you referred to, namely "Any bit of declared side income will do" as something that you had said, and for this I apologize. For people who have peanuts of net self-employment income with many years of net losses, the IRS requires net positive income for m years out of n (I believe it is 3 out of 5), else it is a hobby according to the IRS meaning all losses are disallowed and all income is taxed as "other income" (and no 401k). – Dilip Sarwate May 29 '14 at 20:31
  • Ah, it makes more sense now that you pointed out that quote. No worries. – Phil Sandler May 29 '14 at 20:36
7

It looks like your Solo 401K loan will need to repaid in 5 years. If you borrow too much in order to pay back in this time you run into the typical 401K loan risks, that it is considered a distribution. Don't borrow more then can be repaid in that time.

When you borrow money from your 401K, it is no longer invested in the market. Lets assume that you are borrowing at 6% or so, and your LOC is at 3.5%, and the mutual funds you are invested in are returning 9%. You would be better off with the LOC. As you are paying 3.5% but earning 9%. Keep in mind with a LOC that is variable you have interest rate risk, where you don't really have that with the 401K loan.

I think the 401K loan is riskier then you are allowing. If you do not pay it back within the allotted time, you get nailed for 40% of the unpaid balance. That is quite high. With the HELOC, you can weather quite a few negative credit events without your home ever being in jeopardy.

| improve this answer | |
  • +1. Borrowing from the 401K should generally be a last resort. – keshlam Jun 1 '14 at 4:49

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.