One of the most powerful features of the Self-Directed Solo 401k plan is the ability of plan sponsors to structure their plans to allow for loans against the 401(k) balance. This feature is a popular one, as small business owners are keenly aware of the problem of temporary cash crunches disrupting business activity.

However, owners of Self-Directed Solo 401k or conventional Self-Directed 401k plans should use caution before committing loan funds to investments in certain circumstances. This is because it’s very easy for Self-Directed Solo 401k owners to run afoul of prohibited transaction rules when they use 401(k) loan proceeds to make investments.

Here’s why:

Under Internal Revenue Code Section 4975, disqualified persons (that’s you, the owner, along with your spouse, children, grandchildren, parents and grandparents and those of your spouse) cannot personally guarantee loans made from within your solo 401(k) plan. Any loan that you or any prohibited person must personally sign to guarantee, or for which you or any other prohibited person must put up collateral other than the purchased investment for inside the 401(k) is likely going to break the rule. Any participant in the 401(k) plan is likely considered a disqualified person under IRC 4975.

You can borrow money against your 401(k) for any purpose, but you cannot then pour those proceeds back into a 401(k) investment if you are personally guaranteeing the debt. All mortgages on property held within a solo 401(k) account (or any other tax-advantaged retirement plan, for that matter) must be taken on a non-recourse basis. The lender must have no option to go after you or anyone else in the event of a debt default, other than to foreclose on the property within the 401(k).

So when does it make sense to take out a loan from a 401(k)? It can be a good strategy if you simply need access to cash to bridge a short-term liquidity need – one you expect to be able to pay off in a year or so. One good example: Purchasing a car or truck for business use for a corporation, LLC or partnership – especially one that sponsors your Solo 401(k) plan. Many real estate investors we know who own solo 401(k)s occasionally use loans against their Solo 401(k)s to pay for contractors to get an apartment or house ready to rent – and then aggressively pay back the 401(k) loan with the rent proceeds. If it weren’t for the 401(k) loan option, in some cases they wouldn’t have the cash they needed to turn the rental around immediately, and the home would go unoccupied and idle for that much longer. A 401(k) loan may enable them to get a tenant in the property much sooner – and that would be worth any interest on the 401(k) loan many times over.

Note: Anyone who uses 401(k) loans should be aware that while the original contributions were pre-tax, they must repay the loan with after-tax dollars.