This article originally appeared on Forbes.com –
Hurricane Harvey has set a record for rainfall in the continental United States. It is estimated that some 100,000 homes have been affected by Harvey all with differing degrees of insurance coverage. In addition, at least 37 people have died from the storm.
Over the coming weeks we will be hearing news about payout projections by insurers, but chances are those dollars will flow to the commercial sector, not homeowners. If the 2012 Hurricane Sandy is a predictor, households are facing a severely diminished quality of life, financial frustration, a long process for applying for grants and aid, and way too little insurance funding in relation to the premiums they’ve been paying. Many insurance experts estimate that only a relatively small percentage of the Harvey-impacted homes and businesses will have adequate flood insurance. For those without it, there is a short list of possible bases for coverage under a home policy. However, for Harvey storm victims who are participating in an employer 401(k) plan or who are self-employed, an unorthodox financing option exists that can help storm victims borrow up to $50,000 tax-free and penalty free from their 401(k) plan.
Internal Revenue Code Section 72(p) allows a Solo 401(k) plan participant to take a loan from his or her 401(k) plan so as long as it is permitted pursuant to the business’s 401(k) plan documents. The loan proceeds can be used for any purpose. In order to be eligible to take a loan from a 401(k) plan, the solo 401(k) plan documents must specifically provide for a loan program
In general, to avoid having a 401(k) plan loan treated as a taxable distribution to the recipient, the following conditions must be satisfied (IRC Sec. 72(p)(2)).
- The loan must have level amortization, with payments made at least quarterly.
- The recipient generally must repay the loan within five years, although a fifteen year period can be used for the purchase of a primary residence.
- The loan must not exceed statutory limits.
Generally, the maximum amount that an employee may borrow at any time is one-half the present value of his vested account balance, not to exceed $50,000. The maximum amount, however, is calculated differently if an individual has more than one outstanding loan from the plan. A 401k loan is permitted at any time using the accumulated balance of the solo 401k as collateral for the loan. In other words, a Solo 401(k) participant can borrow up to either $50,000 or 50% of their account value, whichever is less. This loan has to be repaid over an amortization schedule of five years or less with payment frequency no less than quarterly. The lowest interest rate that can be used is prime as per the Wall Street Journal, which as of September 1, 2017 is currently 4.25%. However, if a loan fails to satisfy the statutory requirements regarding the loan amount, the loan term, and the repayment schedule, the loan is in default and is considered a deemed distribution. In addition, another potential disadvantage of taking a 401(k) plan loan is that the borrowed funds are removed from investment in the market, forfeiting potential tax-exempt gains.
For Harvey storm victims participating in an employer 401(k) plan, taking a 401(k) loan can be done generally by contacting the 401(k) plan administrator. Whereas, for individuals who are self-employed or have a business with no full-time employees, other than a spouse or partner(s), a Solo 401(k) plan with a loan option can be adopted quite easily, which will allow such individuals to borrow up to $50,000 and use the proceeds for any purpose, including paying for home repairs, purchasing a car, paying living expenses, paying credit card debt, or other expenses.
In the case of Harvey storm victims, the primary advantage of using a 401(k) loan feature is that the individual will gain the ability to use up to $50,000 of retirement funds without tax or penalty. In addition, the loan payments of principal and interest are paid back by the individual to his/her plan account, thus, increasing the overall value of the 401(k) plan assets over the loan period. Drawbacks of taking a retirement plan loan include the loss of compounding for assets in the plan, as well as the fact that loans are repaid with after-tax dollars, resulting in a loss of tax-free or tax-deferred advantages of such an account.