Loan Programs in Employer-Sponsored Retirement Plans
By Gunnar Kuehl, QKA, CIP
Can a participant in an employer-sponsored retirement plan ever access their plan assets without a distribution triggering event?
Under certain circumstances, plan participants may be eligible to obtain loans from their vested plan balances before the occurrence of a distribution triggering event. Although diverting plan assets for personal use before a permissible distribution usually constitutes a prohibited transaction, plan loans represent a limited exemption to these prohibited transaction rules.
Plan documents must specifically provide for a plan loan program for participants to use this feature. The requirements for plan loans are relatively technical, so plan sponsors should carefully select loan program terms and conditions to ensure that loan eligibility criteria and documentation conform to federal regulations. A number of commercial vendors offer loan kits that conform to these regulations and include all documents necessary to administer a loan program.
What are the potential advantages and disadvantages of allowing plan loans?
Many plan sponsors believe that the availability of loans in retirement plans is an attractive feature. Specifically, participants are more likely to contribute to a plan if they know that they can access a portion of their plan assets while they are still employed—without having to suffer the accompanying tax consequences.
Other plan sponsors may find that the responsibilities involved in administering a loan program outweigh the potential advantages. In addition, participants who are paying back a plan loan may find it harder to continue contributing to the plan. This might conflict with the employer’s goal of promoting retirement savings among their employees.
The plan sponsor’s financial advisors can assist with determining whether a loan feature is right for their plan based on their business goals and objectives.
Which types of retirement arrangements may permit loans?
Plan loans are an optional feature for Internal Revenue Code Section 401(a) plans (such as profit sharing plans, 401(k) plans, and defined benefit plans), 403(a) plans, 403(b) plans, and governmental 457(b) plans. Unlike distribution triggering events, the availability of plan loans is not a protected benefit and so this feature generally can be added, modified, or removed at any time through a plan amendment.
Loans are never permitted from IRAs or IRA-based employer plans such as SEP plans and SIMPLE IRA plans. A loan from these types of accounts will always result in a prohibited transaction, often resulting in significant penalties and tax consequences for the account holder.
What requirements apply to a loan program under an employer-sponsored retirement plan?
A plan loan program must comply with two sets of requirements: the Department of Labor (DOL) requirements must be satisfied to avoid a prohibited transaction, and the IRS requirements must be satisfied to avoid having a plan loan treated as a taxable distribution.
To be exempt from the DOL’s prohibited transaction rules, plan loans generally must
be available to all participants and beneficiaries on a “reasonably equivalent basis” (as defined in the regulations);
not be made available to highly compensated employees, officers, or shareholders in an amount greater than the amount made available to other participants;
be made in accordance with specific provisions of the loan program contained in the plan;
bear a reasonable interest rate; and
be adequately secured (participants may not use more than 50 percent of their vested account balance as security for a loan).
To avoid the IRS treating a plan loan as a taxable distribution to the recipient, the following conditions must be satisfied.
The loan must have level amortization, with substantially equal payments (consisting of both principal and interest) scheduled to be made at least quarterly.
The recipient generally must repay the loan within five years. (An exception exists for loans used to purchase a principal residence of the participant, in which case a “reasonable time” replaces the maximum five-year term.)
The loan must not exceed the statutory limit, which is generally the lesser of 1) $50,000, minus the participant’s highest outstanding balance in the preceding 12-month period; or 2) one-half of the participant’s vested account balance, minus any current outstanding balance.
What happens if a loan payment is missed?
Under IRS regulations, a plan may provide a “cure period” for making up missed payments to prevent a loan default. The cure period may not extend beyond the last day of the calendar quarter following the calendar quarter in which the required payment was due.
Example: A loan issued in January 2022 has biweekly payments scheduled to commence that month. Due to an administrative oversight, no payments are made until the plan sponsor discovers the error in May 2022. The plan document allows for the maximum cure period for missed payments.
To prevent a loan default, all scheduled first quarter payments must be made up by June 30, 2022 (i.e., the end of second quarter). Likewise, all scheduled second quarter payments must be made up by September 30, 2022 (i.e., the end of third quarter).
If a missed loan payment is not made up within the cure period (if any), then the loan will go into default, which is an operational failure for the plan. The IRS provides guidance on how to correct a loan default in their Employee Plans Compliance Resolution System (EPCRS), found in Revenue Procedure 2021-30. Corrective options may include deeming the loan as a taxable distribution, re-amortizing the loan, or making a lump-sum repayment.
The details of loan corrections are complex and should be addressed in consultation with a compliance specialist or other competent tax or legal counsel. Better yet, plan sponsors should work with their service providers to ensure that loan payments are made as scheduled to avoid need for corrective action.
