- Introduction
- Background
- Loan Requirements
- Plan Document
- Loan Policy
- Maximum and Minimum Amounts
- Number of Loans
- Interest Rate
- Amortization
- Other Repayment Terms
- Documentation
- Conclusion
If you have a 401(k) plan, you’ve likely had participants
ask about taking loans from their accounts. If you haven’t yet, it is only a
matter of time. While the concept of taking a loan is pretty straightforward—you
borrow money, you repay it with interest—there are some pretty detailed
rules that govern loans in the retirement plan world.
One of the advantages that qualified retirement plans provide is that there
are strict rules designed to protect plan assets from misuse, either accidental
or intentional, by plan fiduciaries or other interested parties. One of those
rules is a prohibition against the plan loaning money to pretty much anyone
except in very limited situations.
One such situation is a loan to a plan participant, but only if a series of
detailed requirements are met. In other words, all participant loans start out
prohibited and only become allowable if all of the regulatory hoops are jumped
through. It’s an “all or nothing” proposition, so even the slightest misstep—no
matter how picky or insignificant it might seem—can invalidate the loan,
subject the participant to taxes and penalties and jeopardize the plan’s
compliance. Have no fear, however. Most of the loan rules are reasonably easy to
follow once you are aware of what they are and how they are applied.
Most of the loan rules are written as “bookends” of sorts in that they
describe the outside limitations and allow flexibility within those parameters.
For starters, the plan document must specifically authorize participant
loans. This might be as simple as checking the appropriate box in the adoption
agreement or adding a few sentences to an individually-drafted-type document.
Unlike many plan provisions that require adoption before they can be
offered/applied to participants, a participant loan feature can often be
implemented at any time during the year as long as the plan document or
amendment formally adopting it is signed no later than the last day of the plan
year of implementation.
With that said, it is important to ensure that loan availability is
adequately communicated to all participants (and not just the highly compensated
employees, owners, officers, etc.) so that it is not indirectly discriminatory.
If, for some reason, loan availability does not make it into the plan
document on time, the IRS has a correction program that makes it relatively easy
to retroactively amend.
In addition to specifically authorizing loans, the plan must also have a
written policy that details all of the parameters that will govern those loans.
The rest of this article will explore those parameters in more detail, but
examples include maximum and minimum amounts, interest rate, processing fees,
repayments terms, etc.
Some plans incorporate these details into the plan document itself, while
others have a separate administrative policy that spells out the parameters.
Once documented, those details must also be communicated to participants,
usually by including them in the plan’s Summary Plan Description or providing a
copy of the administrative loan policy.
There is a fair amount of flexibility in modifying loan parameters; however,
it does require a formal written update, usually subject to the same timing
requirements described above. If the updated parameters are not formally adopted
within the necessary time frame, retroactive correction—if available at
all—requires an application to the IRS to request approval.
Because loans start out prohibited and only become allowable if they fall
within all of the regulatory limitations, issuing a loan outside those criteria
and not seeking IRS approval to correct means that those problem loans are
deficient from inception and can taint the plan’s compliance for years to come.
So, even though a misstep might seem insignificant in the grand scheme of
things, voluntarily correcting it is usually going to be far less troublesome
and expensive than what would happen if the IRS discovers it in an audit.
First, let’s take a look at the maximums imposed by the regulations.
Participants can only take loans totaling up to 50% of their vested balances.
The determination is made when the loan is issued, so it is not a problem if a
participant takes the maximum loan and a subsequent market decline causes the
loan to exceed half of the remaining balance. If a plan allows multiple loans,
then the balance of any existing loans must be added to the new loan amount to
ensure the total is within the 50% limit.
Even if a participant has more than $100,000 in his or her account, the
maximum combined loan balance cannot exceed $50,000. The $50,000 maximum must be
reduced by the highest outstanding loan balance a participant had in the 12
months ending on the date a new loan is issued. So, if someone takes a $30,000
loan on January 1st and repays it June 30th of the same year, he or she is
limited to only $20,000 in additional loans until December 31st (12 months after
the initial loan was taken) and continues to be limited until June 30th of the
following year (12 months from the date the initial loan was repaid).
Although it is possible for a plan to impose smaller caps than these
regulatory limits, it is somewhat unusual to do so.
On the other end of the spectrum is a loan minimum, the most common of which
is $1,000. Because of the vested balance limitation, imposing a minimum of
$1,000 means that a participant must have a vested balance of at least $2,000 to
take a loan. For that reason, setting a minimum threshold that is higher than
$1,000 is generally considered discriminatory, because it impacts lower paid
employees more than higher paid ones. It is not uncommon for a plan to set a
lower minimum of maybe $500; however, a lower threshold usually means more
loans.
The law does not impose a maximum beyond the amounts noted in the previous
section. That means a plan could allow a participant to have five, ten or an
unlimited number of loans at one time as long as the total remains within the
amount parameters. In practice, however, many plans limit participants to only
one or two loans at a time to minimize the administrative burden or to keep
participants from using the plan as a revolving account.
One area where this requirement might not be as straightforward relates to
refinancing of existing loans. Similar to mortgages, participant loans can be
refinanced if the plan permits. The loan regulations describe refinancing as
consisting of two loans at the time of the transaction—the replacement loan and
the replaced loan. This means that unless the loan policy has overriding
language, a participant with an outstanding loan is prohibited from refinancing
that loan if the plan has a one-loan-at-a-time limit.
Regulations indicate that the interest rate on a participant loan must be
similar to what a commercially reasonable rate would be for a loan of similar
terms. For convenience, many plans set the interest rate as a factor of the
published prime rate, e.g. prime +1% or +2%. The IRS has indicated that this
method is not a “safe harbor”; however, if you check with commercial lending
institutions, the going rate for a fully secured loan seems to be in that
general range.
Even though prevailing interest rates are subject to change over time,
participant loans are not variable rate loans. In other words, the interest rate
is fixed at the time the loan is issued and remains at that level through the
life of the loan.
The maximum length of time a participant loan can be outstanding is five
years. There is an exception for a loan the participant intends to use to
purchase his or her primary residence (not a second home or vacation home). In
that case, the duration is sometimes limited to the length of the first mortgage
on the home, but many plans limit it to only 10 or 15 years. It is not unusual
to stick with the same five-year limitation for all loans so that there is no
need to collect further documentation to support the longer amortization.
There are a few other repayment terms that are important:
Method: The law doesn’t really impose any restrictions
here, but plans typically require participants to repay their loans through
payroll deduction. Since plan fiduciaries are responsible to ensure timely
collection of amounts owed to the plan, using payroll deduction helps ensure
timely and proper repayment. It is possible to accept other forms of payment
such as personal check or certified funds; however, since an insufficient funds
issue can create significant administrative headaches, any additional payment
flexibility is typically limited only to former employees and only to money
order or certified check.
Employment Termination: Speaking of a participant
terminating employment with an outstanding loan, each plan can determine the
repayment terms in that situation. If payroll deduction is the normal form of
payment, a plan may have an “acceleration” clause that requires the participant
to repay the entire loan in full. Alternatively, the former employee could, as
noted above, be permitted to submit regularly scheduled payments via some other
method. Regardless of the option selected, if the former employee does not make
timely payments, the entire outstanding balance of the loan is treated as a
distribution, subject to regular income tax and an early withdrawal penalty if
the individual is younger than age 59½.
Frequency: Regulations say that level payments of
principal and interest must be made at least quarterly. Since payments are
usually made through payroll deduction, the amortization typically follows the
employer’s payroll schedule, e.g. biweekly, semi-monthly, etc.
Taxation: Retirement plan contributions receive
special tax treatment at the time of deposit. As a result, loan repayments are
made on an after-tax basis. This is true regardless of whether the loan proceeds
were issued from pre-tax or Roth sources.
Participant loans must be documented. It might be via a printed and signed
agreement, or it may be via electronic documentation and consent. Either way,
the documentation must be in writing. One reason for this is that regulations
require participant loans to be enforceable under state law, and state laws
generally require any sort of “commercial” loan to be written.
As you can see, there are quite a few moving parts to participant loans.
Fortunately, most of them are pretty easy to follow once you are aware of them.
It is worth noting that these rules are designed to protect plan assets from
misuse and preserve tax-favored retirement benefits. As such, the IRS and DOL
both tend to enforce those rules in a rather strict, black-and-white sort of
way.
It might be tempting to “help” a participant who needs a little more than
what is available or wants to discontinue payroll withholding. But, since
following the loan rules is an all-or-nothing prospect (at least from a
compliance perspective), what is intended to help a participant could actually
result in significant taxes and penalties to him or her as well as the plan. By
proactively considering each of these provisions, having a clearly documented
loan policy and communicating it to participants, a loan provision can be smooth
sailing.
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