Retirement plans are designed for retirement, right?  Right.  But having a significant asset can be very tempting for a participant who needs cash now.  There is no ATM on a 401(k) plan, but many employees take advantage of the loan provision in their retirement plan, and some abuse the privilege.  Is a loan provision in your plan the right thing for you and your employees?  This article outlines how the loan provisions work from an administrative perspective, and offers some pro-and-con considerations too.  Contact one of our pension consultants to discuss your plan in further detail.

Loans are optional.  Offering loans is optional, and the provision may be added or discontinued at any time through an amendment to the plan.  If offered, the loan program must be available to all participants on a non-discriminatory basis.

Loan restrictions.  The plan may put restrictions on loan requests.  Such restrictions include:

• Hardship reasons only (home purchase, education or medical expenses, etc.)
• Source limits (this would limit what funds are available to take the loan from, for example, elective deferral source only, or not from employer or Prevailing Wage sources, etc.)

Loan limits.  The amount of a loan is limited under the law (IRC §72(p)) as follows:

• Minimum is $1,000
• Maximum is the lower of:
  • $50,000; or
  • 50% of the vested account balance of the participant
• The number of loans may be restricted too. Many plans allow for only one loan with no refinance privileges. 

Interest rate.  The interest rate charged to participants for a loan must be “reasonable”.  Most plans offer loans at Prime Rate plus 1% or 2%.

Loan payments.  Loans must be repaid to the plan with a level amortization schedule of principal and interest payments.  The payment period cannot extend beyond five years.  There may be an exception for home purchases if the plan allows for such. 

To protect the plan from a loan going into default for failure to make payments properly, most plan sponsors require that loan payments be taken via after-tax payroll deduction.  As long as the employee is earning a paycheck, the loan payments will be deducted and remitted to the investment custodian.  Payments can be no less frequently than quarterly.

Pre-payments can be made without penalty.

Defaults.  Failure to make payments according to the regulations result in the loan going into default.  The default occurs at the end of the quarter following the quarter that the last payment was made.  Default results in taxability (and possible early withdrawal penalties) of the principal amount of the loan at the time of the default.  Default does not eliminate the obligation to the participant to repay the loan, however.  The loan will remain due as long as the participant is an active employee.  Payments made after default are “basis” in the plan, and will not result in a taxable distribution later.

Mistakes can be fixed.  The IRS has a program to fix loan violations that they call their Employee Plans Compliance Resolution System (EPCRS).  If a loan was for more than the maximum, if payments weren’t made properly, if the term of a loan extended beyond the maximum time frame, etc. a request can be submitted to remedy the failure.  The IRS filing fee for an EPCRS submission is usually $3,000 or more, plus the fee to prepare the submission by your attorney or TPA.

Are retirement plan loans a good idea for your plan?

PROS

• Participation in a qualified retirement plan may improve if there is a loan program
• Participants like the idea of paying themselves interest instead of paying a bank
• A loan program could help in employee retention. If the employee can borrow from the plan, they don’t have to quit to have access to funds in their retirement account.

CONS

• Loans are paid back with after-tax dollars, and when the account is eventually distributed to the employee those assets are taxed again
• There is additional administrative burden on the plan sponsor when there is a loan program:
  • Processing and/or approving applications
  • Setting up deductions in payroll
  • Monitoring payments to start and stop at the right time
• Without limits, the program can get out of control
  • Some employees will take multiple loans in a year for small amounts
  • Refinancing gets tricky, especially if the original loan is for the full 5-year term
• Termination of employment often results in a taxable event to the employee of any outstanding loan balance. The Tax Cuts and Jobs Act of 2018 allows for repayment/rollover of loans up to the due date of the personal return, but this could still prove to be burdensome for employees.
• Failure to follow all of the rules can result in significant expense to the employer.

Loan programs are very popular with plan participants, but not always with plan sponsors.  Consider the pros and cons carefully and understand the risks as a plan sponsor before offering loans to your plan participants.  If you have questions about loans or plan design in general, contact our pension consultants today.

You might also like:

Hardship Withdrawal Guide

Common Retirement Plan Problems and How to Fix Them

Best Practices in Pension Administration for Employers

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