Forbes: Entreprenuers In Need Of Cash Turn To The Solo 401K

[neverfastenough]

Coming Up With Cash In A Pinch - Forbes.com

For entrepreneurs, getting through these financially turbulent times may require some imaginative solutions to vexing problems of liquidity. Keeping suppliers paid or just keeping the lights on can be a challenge when accounts receivable get tougher to collect and bank loans look like pipe dreams.

Situations like these can cause business owners to resort to desperate measures, even raiding retirement accounts for working capital. But raiding some types of accounts--if you must--will do less damage than others.

The "Solo 401(k)" or "Individual 401(k)" is designed specifically for a business owner who has no full-time employees. One of the most powerful benefits of the Solo 401(k) is the plan's participant loan feature, which offers a tax-favorable alternative to withdrawing money from a retirement plan as a distribution.

Let's imagine that a married and self-employed 47-year-old financial planning client, Randy, comes to you saying, "I need money now. I can't get a bank loan due to tough lending standards. My $150,000 IRA is the only source of money I have and I need about $50,000 out of it."

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Randy is in a bind for several reasons. First, taking an IRA distribution will trigger tax liability. In fact, Randy will pay income tax on the distributed amount plus a 10% penalty because he's under the age of 59 1/2. And once he withdraws the money, he's not allowed to pay it back to the account later.

The taxes and penalties applied to the distribution often become the focal point when this option is discussed, but a simple forecast of the distribution's long-term impact on the participant's future is even more bothersome.

Let's assume Randy was on track to average 8% returns annually, he's at the 25% income tax bracket and his decision to take the distribution wouldn't change his income tax bracket. To net $50,000, Randy would have to take a distribution of $76,950. The difference between the distributed amount and the net amount is his 25% ordinary income tax plus the 10% early distribution penalty that he'll pay to the IRS. This distribution will derail Randy from growing his $150,000 IRA into $699,143 over the next 20 years. In fact, in 20 years he'll come up $358,660 short.

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There's a better way to do this. As a self-employed person, Randy has the opportunity to set up a Solo 401(k) and initially fund it with a tax-free rollover comprising all his IRA funds. He is then eligible for something an IRA can't do: a participant loan. A Solo 401(k) participant can take a loan from his own account, up to $50,000 or 50% of the account value, whichever is less, without taxes or penalty. If Randy did this, he would need to pay back the $50,000 to his Solo 401(k) amortized over a maximum repayment period of 60 months.

Using this strategy, Randy does much better. He pays no taxes on the receipt of loan proceeds, and the money borrowed is repaid into his tax-favored 401(k) account for further investment. Plus, because there are no taxes involved in a participant loan, Randy doesn't need to take out a penny more than the $50,000 that he needs. Randy has more money working in his investment account than if he took an IRA distribution.

Secondly, as Randy pays back the loan over five years (participant loans must carry a reasonable interest rate, which is interpreted as 1% above the prime rate (which works out to 4.25% at the time this article was published), the borrowed money and interest would go back into his Solo 401(k) account and be put back to work creating investment returns. The result? At the end of the total 20-year period with 8% average annual returns, Randy ends up with $692,714. That's $352,464 more than he would have at the end of the period if he had taken the distribution instead of the participant loan and only $6,429 less than if he had taken no loan or distribution at all.

From this scenario, you can see how it is more beneficial for Randy to take a participant loan rather than the distribution, as long as he is able to repay the loan to his Solo 401(k) over the five-year amortization. The key to ensuring he doesn't take a huge hit is that he makes the repayment back into the 401(k) for further investment.

It's also important to note a few other things. The interest rate is fixed for the life of the loan and won't change over the term of the loan. Also, while a five-year amortization is the maximum (paid either monthly or quarterly), the loan can be set up for a shorter repayment period, and there are no prepayment penalties.

With the economy still looking tough and lending tight, cash-strapped small-business owners are left to fend for themselves these days. The Solo 401(k)'s participant loan feature enables small-business owners to tap into their capital, making it easy to give themselves their own personal bailouts.

 

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