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