FREQUENTLY ASKED QUESTIONS RELATED TO LOANS
In recent years, IRS and DOL audits have placed an increased emphasis on participant loans. Specifically, they have focused on making sure active participants continue to make their loan repayments in a timely manner, loans are processed according to Section 72(p) and the plans loan policy, as well as ensuring loans are defaulted properly. If you are a small business owner with a defined contribution and a loan outstanding, it will be scrutinized closely.
This FAQ addresses the key areas of operation for our clients as well as including our most popular questions from plan sponsors, investment advisors, and recordkeeping service provider platforms.
What interest rate should a plan sponsor select?
The Department of Labor defines reasonable rate of interest as a rate that “provides the plan with a return commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances.” DOL Reg. § 2550.408b-1(e).
If this seems open to interpretation, the industry has adopted best practices to include the loan rate as the prime rate plus 1 or 2%. The prime rate is the interest rate banks charge their most creditworthy customers. Adding one or two percent to the prime rate does make the interest rate charged to the participant more consistent with general consumer rates, as individuals can rarely get a loan at the going prime rate.
What are the minimum and maximum loan amounts?
This is not a straightforward calculation for those participants with an outstanding loan in the last year (including those that have been paid off). The Internal Revenue Code Section 72(p) regulations limit the maximum loan amount to the lesser of:
- No more than 50% of the participant’s accrued benefit, or
The $50,000 maximum must be reduced by the difference of the highest outstanding balance from the previous year minus the current outstanding balance.
The plan loan policy may set a minimum loan amount. As long as the minimum amount is $1,000 or less, the plan does not violate the requirement that loans be made available to all participants on a reasonably equivalent basis.
Plan sponsors should consider the fees charged by the recordkeeping service provider when determining a minimum as well as making sure the fees are clear to the participant!
What is the maximum repayment period for a plan loan?
Plan loans must be repaid within five years from the date of the loan. If the purpose of the loan is to acquire a primary residence and the plan document/loan policy permit; the loan term can exceed the five year limit.
The IRS defines the “date of the loan” as the date that the loan is funded, which, in their example, is the date the check is delivered.
An active participant tells the plan sponsor to stop loan repayments immediately. Does the plan sponsor have to accept this request?
In a nutshell, this transaction is not allowed. On other words the plan sponsor should deny the request. Background includes:
- It is considered an operational error (failure to follow the terms of the loan program, which is a legal plan document)
- It is a fiduciary breach in that the plan sponsor (the Plan Administrator) is knowingly allowing for and participating in the default of an enforceable agreement between the participant and the Plan.
The law is the law, and the plan sponsor is obligated to follow the law or risk the retirement benefits of all the other participants. Although it appears harsh, denying this request protects the qualified status of the plan and all participants.
A participant has informed the company and plan sponsor that they have filed for bankruptcy. What should the plan sponsor do with the loan and loan repayments?
On April 20th, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “Act”) into law. One of the stated goals of the Act is to “[restore] personal responsibility and integrity in the bankruptcy system and ensure that the system is fair for both debtors and creditors.”In 1992, the Supreme Court ruled that ERISA-qualified plans such as 401(k) and profit sharing plans are automatically excluded from the bankruptcy estate under federal law; however, non-ERISA plans such as IRAs, 457 plans and 403(b) plans were subject to the bankruptcy laws on the individual states. Thus, an individual’s IRA accounts, for example, could be included in the bankruptcy proceedings in some states but not in others. The Act brings these various retirement plans under federal bankruptcy protections. For non-rollover IRAs, only amounts up to $1 million are protected, but the courts are specifically permitted to increase this cap if “the interests of justice so require.” Employer-sponsored plans, SEPs, SIMPLEs and IRA rollover accounts have unlimited protection.
Under the Act, the obligation to repay a participant loan from an employer-sponsored retirement plan is not affected by a bankruptcy filing. Not only must a participant continue to make regularly scheduled payments pursuant to the original loan agreement, but the amount of the regular payment is deducted from that individual’s income in establishing whether or not the needs-based test is satisfied for discharge of other debts.
A participant requests and accepts the loan online and wants to reverse it? Can the plan sponsor reverse it?
This is one of those questions that must be responded with a question or two. Did the participant accept the provisions of the loan online or in paper, and authorize? Did the plan sponsor accept provisions of the loan (electronic or written approval)?
If the answer is yes and three days have gone by then the loan is most likely enforceable under state law and the participant should proceed with their first payment.
This question is ultimately a plan sponsor (fiduciary) decision, and if they want to cancel it (and are indicating in a fashion that is urgent), we recommend the recordkeeping service provider receive an indemnification email from the plan sponsor to document the decision. These questions tend to come up with plans in an electronic environments. It is interesting to note that most of these platforms go out of their way to make sure the participant knows they are authorizing and accepting a loan so as to avoid this event.
Same question as above, but the participant held on to the check without cashing it for 3 months?
A participant cannot claim they were waiting to see if they really needed the monies before cashing it or indicate they never received it.
The information related to the participant not needing the money should not be a factor in the decision because the participant accepted the provisions of the loan at that time (as opposed to accepting the provisions of the loan and all fees just in case they needed the funds at a later date only if they really needed it). By accepting the provisions of the loan the plan sponsor should have started the loan repayments in a timely manner as well.
IRS and DOL agents review all outgoing monies from at trust and will ask for the documentation for each event (if audited). The monies leave the trust when check is cut (not when it is cashed). The IRS defines the “date of the loan” as the date that the loan is funded, which, in their example, is the date the check is delivered. The monies have been out of the plan and the participant agreed to a repayment schedule which must start in a timely fashion.
We typically get this question from small plans whereby the transaction is related to an owner or HCE of the company. In these cases, it is even more important that they act prudently as they are a fiduciary. Of course, if the participant did not receive the check, they should request a stop payment and reissue.
We also recommend the participant pay accrued interest on their outstanding loan repayments if they are in catch-up mode.
When should loans be defaulted and by whom?
The default should be decided by the plan sponsor/fiduciary and they should authorize their recordkeeping service provider to do as such when the event is required (worst case by the end of the year since most recordkeeping service providers/custodians send the 1099R's in January for the previous years distributions).
Although some plan sponsors want the recordkeeping service provider or TPA to perform this function, the recordkeeping service provider/TPA is in a tough position, for example:
- If they default the loan, the plan sponsor may react adversely
- If they do not default the loan, the plan sponsor has a hedge in case of audit
- This is a plan sponsor decision as they have all of the facts (think of military leave or the participant that missed one or two payments)
Best practices are for the ERISA consultant and the plan sponsor to work together at least annually to review outstanding loans.
Loans should be defaulted when the participant has missed the cure period for correcting the loan. The cure period is the last day of the quarter following the quarter of the missed payment. According to 72(p)(2) the default includes the unpaid balance and interest accrued through the date of the default.
How do I handle a loan request for a participant that has a defaulted loan already?
From an outsiders perspective, this seems to be a risky event for a plan sponsor since they already defaulted on one loan. Having said that, per Reg 1.72(p)-1, Q&A-19(b)(2), establishes additional requirements for the participants loan request. If the following two conditions are not satisfied, the subsequent loan is treated in its entirety as a deemed distribution under Section 72(p):
- Repayments are made under a payroll withholding arrangement that is enforceable under applicable law
- The plan receives adequate security from the participant that is in addition to the participant's accrued benefit under the plan (such as other collateral)
Title I of ERISA treats this subject seriously, so it is crucial if this loan is made, the fiduciary takes steps to ensure that the loan is 'real' and is not merely a transfer of plan assets to the participant (defined by the IRS as a sham loan). Owners and trustees who have defaulted on loans before, also have the risk that the IRS may rule that the first loan be deemed a sham loan.
If you are the plan sponsor and are still proceeding with the loan, the loan availibility is calculated like any other loan but you must add the accrued interest from the previous defaulted loan (presuming the loan default was in the last year).
IMPORTANT: Plan Sponsors that cease automatic payroll loan repayments for an active participant
If you as a plan sponsor cease automatic payroll loan repayments for an active participant, please notify your recordkeeping service provider and/or ERISA consultant immediately. This event should only occur for ERISA acceptable events and must be thoroughly documented.
If your plan has loans and we have indentified potential loan issues related to loan delinquency, please proceed to review each of the participant loans to determine if they should be deemed distributed (resulting in a taxable event to these participants). Unless these participants qualify for an exemption to defer payments (such as medical or military leave), these loans need to be caught up immediately or deemed. Technically, if the participant has not made up a missed loan repayment by the end of the following calendar quarter, the loan is in default and should be deemed distributed.
What ERISA rules apply to plan loans to participants to avoid a deemed distribution? In other words, what should the plan sponsors loan policy include and how should the plan sponsor handle loans?
ERISA has five requirements for plan loans to participants. If the requirements are not met, the loan is a deemed distribution. Plan loans must:
- Be available to all participants and beneficiaries on a reasonably equivalent basis,
- Not be available to highly compensated employees in an amount greater than that available to non-highly compensated employees,
- Be made according to the requirements of the loan policy of the plan,
- Bear a reasonable rate of interest
- Be adequately secured
Section 72(p) of the Internal Revenue Code provides guidance in designing and implementing a plan loan policy, they include defining the maximum loan amount, maximum loan repayment period, level amortization of payments, and a legally enforceable agreement.
The content of this website is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances.