In Borrowing From Your Retirement Plan:Pros, Cons and Guidelines, we look at the factors a participant may consider when requesting a loan from his or her qualified-plan account. Here we review the general guidelines for an employer who wants to add a loan feature to the business's qualified plan.
Why Add a Loan Feature?
Adding a loan feature will make the plan more attractive to employees. If your plan is a 401(k) plan, the loan feature may serve to encourage employees to participate in the plan, as they would know that the assets are available for them to borrow when necessary. And, if employees borrow from their own plan, they make interest repayments to their own accounts instead of to a financial institution.
Who Can Borrow?
Prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), anyone who was at least a 5% owner of a business was not allowed to borrow from that business's qualified retirement plan. Effective for tax years beginning 2002, however, all eligible employees, including business owners, are allowed to borrow from the qualified plan of a business. The business owner is subjected to the same rules that apply to other plan participants.
Plans that May Offer Loans
Loans may be allowed from qualified plans, such as profit-sharing plans, money-purchase pension plans, defined benefit plans, target benefit plans and 401(k) plans. Loans may also be allowed from 403(b) plans. Generally, an employer must "elect into" the loan provision when completing the adoption agreement for the qualified plan.
IRAs and IRA-based employer plans do not allow loans.
Generally, the Internal Revenue Code (IRC) prohibits loans from qualified plans for plan participants or their beneficiaries. However, the loans are allowed if the following criteria are met:
1.The loan is made available to all participants or beneficiaries on a reasonably equivalent basis
The criteria for a reasonably equivalent basis are the following:
- The loan is made available to all plan participants and beneficiaries without regard to an individual's race, color, religion, sex, age or national origin.
- Loan considerations are given only to those factors that would normally be considered by an entity in the business of making similar types of loans. Such factors include things like the applicant's creditworthiness and financial need.
- In actual practice, loans are not and have not been unreasonably withheld from any applicant.
2. The loan for highly compensated employees is not greater than the loans made available to other employees.
3. The loan is made in accordance with specific provisions set forth in the plan or a written document.
Plan participants should be provided with the loan provisions in writing. These provisions should include but are not limited to the following:
- The identity of the person or positions authorized to administer the participant loan program.
- The procedure for applying for loans.
- The basis on which loans will be approved or denied.
- The limitations (if any) on the types and amount of loans offered.
- The procedure for determining a reasonable rate of interest.
- The types of collateral that may secure a participant loan.
- The events constituting default and the steps that will be taken to preserve plan assets in the event of such default.
To ensure participants are aware of documentation requirements, the loan administrators should also provide employees with notification of the documents that must be completed to apply for a loan.
1. The loan bears a reasonable rate of interest
A reasonable rate of interest is similar to what an entity in the business of lending money would charge under similar circumstances. Prior to giving a loan to an individual, the plan trustee may contact local banks to find out under what terms the banks would offer a loan to an individual with the same creditworthiness and collateral as that of the loan applicant.
A plan loan that is offered at a considerably lower interest rate would not be bearing a reasonable rate of interest. For instance, if the plan trustee found that two institutions offered similar types of loans at an average interest rate of 10%, but the plan offered the loan at a rate of 5%, this loan will not have met the requirements of the IRC.
2. The loan is adequately secured
A plan loan must be secured so that, in the event the participant is unable to repay the loan, the security is available to satisfy the participant's outstanding loan obligation. A participant's loan may be secured by up to 50 percent of the participant's vested balance under the plan. In the event the loan exceeds 50 percent of the participant's vested account balance, the loan may be secured by assets, which can be sold, foreclosed, or otherwise disposed of upon default of repayment of the loan--the proceeds would be used to satisfy the participant's outstanding loan obligation. Generally, the security would be similar to that used by a commercial lending institution for a similar type of loan.
A plan may require that loans to plan participants cannot be less than $1,000. A plan participant may borrow up to 50% of his or her vested plan balance or $50,000, whichever is less. An exception may be made to allow employees to borrow up to $10,000, even if this exceeds the 50% limit.
If the employer maintains more than one qualified plan, the loan limits do not apply separately to each plan. Therefore, the participant's vested balance and loan activity under all of the employer's plans must be considered when determining permissible loan amounts.
| Example 1
Employee A has a balance of $60,000 in ABC Company\'s 401(k) plan, and, of this amount, the vested balance is $30,000. Employee A is therefore allowed to borrow up to $15,000 ($30,000 x 50%) from the plan.
| Example 2
Employee B has a balance of $120,000 in ABC Company\'s 401(k) plan, and this amount is fully vested. Employee B is allowed to borrow up to $50,000 from the plan - even though 50% of $120,000 is $60,000, the maximum dollar amount allowed is $50,000.
| Example 3
Employee C has a balance of $18,000 in XYZ Company\'s profit-sharing plan, and employee C may borrow up to $10,000 from the plan. Although $10,000 is more than 50% of employee C\'s vested balance, the plan allows an exception whereby the participants may borrow up to $10,000. In this case, because the loan will exceed 50% of the participant\'s vested plan balance, the plan may require additional security for the loan.
Note: Not all plans allow this exception to the 50% rule.
For plans that allow multiple loans, a special formula must be used to determine the maximum amount for additional loans. An employer may want to use the services of a third-party administrator to ensure that multiple loans meet the requirements of the IRC.
Loan repayments are made with after-tax assets and are usually paid according to the loan amortization schedule. Regulations require loan repayments to be made at least quarterly and in level amortized amounts. Each payment should include an allocation of principal and interest amounts. Generally, balloon payments are not acceptable for qualified plan loans. An exception may be made for an employee whose loan repayment was suspended due to a leave of absence but must still be repaid within the originally scheduled time frame. In this instance, the employee may make a lump-sum payment at the end of the loan repayment period.
A qualified-loan repayment period cannot exceed five years, unless the loan is used towards the acquisition of the participant's primary residence.
A plan may require the employee to make loan repayments through payroll deductions. As part of the loan application process, the employer should obtain the employee's written authorization allowing paycheck deductions for loan repayments.
Generally, loans are not considered a reportable or taxable transaction. However, loans that do not meet these general requirements could be considered a deemed distribution, which means the amount is subject to income tax, and, if the participant is under the age of 59.5, the amount may also be subjected to the 10% early-distribution penalty. A deemed distribution is not eligible to be rolled over to another retirement plan.
A plan may be required to report a loan balance when the participant's account balance is used to offset the loan, that is, when the participant's balance is reduced by the outstanding loan amount and the loan is removed from the plan. Generally, an offset occurs when the participant is separating from service with the employer that sponsored the plan and the plan requires immediate repayment of the loan. A loan offset may be rolled over to an eligible retirement plan. Restrictions may apply to deemed distributions and offsets, so the employer should consult with the plan administrator to ensure that transactions meet regulatory requirements.
A plan may be subject to the Federal Reserve Board\'s Regulation Z ("truth in lending") rules if the plan provided more than 25 loans in the preceding year or if more than five plan loans taken in the current or preceding year are secured by a dwellings.
If plan distributions are subject to certain annuity requirements and the participant is married, his or her spouse may be required to approve the loan if the plan balance is being used as security for the loan. Spousal consent is not required if the plan balance used as security for the loan does not exceed $5,000.
Exceptions to Repayment Period for Members of the Armed Forces
If you are an employer considering the addition of a loan feature to your qualified plan, you now have the primary reasons and guidelines for doing so. Your employees will have the security of knowing that assets are available for them to borrow, but it is important that both employer and employee meet the criteria and guidelines set out by the IRC.