Benefits of Allowing Loan Refinancing in Qualified Retirement Plans
By Kristoffer Aas, QKA, EdM
Many employers believe that offering loans in qualified retirement plans is a major benefit. Participants have easier access to their savings, in case of an unexpected financial need, and the employer can elect to use payroll deductions to credit loan payments back to the participants’ accounts for administrative ease. Employers may also offer a plan loan refinancing feature which, while administratively complex, can serve a variety of purposes.
If a participant has taken a loan for less than the maximum term (typically five years), loan refinancing can further expand the amortization repayment period.
If a participant has multiple plan loans, loan refinancing can combine the loans into one loan. This may allow more loans if the participant has reached the plan’s maximum number of loans.
If a participant cannot take more loans, loan refinancing can allow additional amounts to be taken under an existing loan.
If a participant’s loan interest rate is high, loan refinancing can help renegotiate it if economic conditions warrant.
NOTE: If loans are combined, the new loan’s term cannot be longer than the first-ending term of the pre-combined loans. If this requirement is violated, the loan is immediately taxable to the participant. Also, the plan document will determine how many times a loan can be refinanced.
Loan refinancing repays an existing loan (known as the replaced loan) and replaces it with a new loan (the replacement loan). As the new loan is created, it must resatisfy the loan requirements. The following factors must also be considered when determining all other outstanding loan balances.
If the replacement loan’s term is longer than the maximum permissible term of the replaced loan, both loans are treated as outstanding on the refinancing date. This affects the total available loan amount—including the availability of additional funds.
If additional funds are borrowed, the new replacement loan and the replaced loan can be treated as two separate loans as long as each loan satisfies the loan requirements and is repaid by the end of the separate maximum permissible terms. If an employer allows more than one loan, this could be completed as two completely separate loans (e.g., no refinancing) or, if only one loan is allowed, combined into one loan (refinancing).
NOTE: If the replacement loan, (taking into account all other outstanding loan balances, including the replaced loan) exceeds the statutory limits, the excess of the replacement loan is treated as a deemed distribution. Similarly, if a full loan (not just the excess) has been deemed distributed, it can no longer be refinanced.
Example 1: Refinancing within the replaced loan’s term with no additional funds
Participant A took a $30,000 plan loan on January 1, 2020. The loan had a five percent interest rate amortized over four years and $700 monthly payments.
On June 1, 2022, participant A refinanced the $19,000 outstanding loan amount (adding no additional funds) with a three percent interest rate and a new term ending December 31, 2025.
The highest outstanding balance in the past 12 months was $26,000.
The participant’s vested account balance on June 1, 2022, was $120,000.
The maximum statutory loan amount is the lesser of 1) $50,000 minus the participant’s highest outstanding balance in the last 12 months; or 2) half of the participant's vested account balance minus any current outstanding balance.
The lesser of ($50,000 - $26,000 = $24,000) or ($60,000 - $19,000 = $41,000) is $24,000.
Participant A may refinance the loan because the $19,000 replacement loan is less than the $24,000 maximum statutory loan amount. The participant will have new $480 monthly payments.
Example 2: Refinancing beyond the replaced loan’s term with additional funds
Participant A took a $30,000 plan loan on January 1, 2020. The loan had a five percent interest rate amortized over five years and $570 monthly payments.
On June 1, 2023, participant A refinanced the loan (adding $14,000 in additional funds) with a three percent interest rate and a new term ending June 1, 2028.
The highest outstanding balance in the past 12 months was $22,000.
The current outstanding balance on June 1, 2023, was $16,000.
The participant’s vested account balance on June 1, 2023, was $120,000.
The maximum statutory loan amount is the lesser of 1) $50,000 minus the participant’s highest outstanding balance in the last 12 months; or 2) half of the participant's vested account balance minus any current outstanding balance.
The lesser of ($50,000 - $22,000 = $28,000) or ($60,000 - $16,000 = $44,000) is $28,000
Because the replacement loan’s term extends beyond the replaced loan’s maximum permitted term, both loan balances are considered outstanding at the time of the refinancing. As a result, the refinancing is not possible because the $46,000 replacement loan ($16,000 current outstanding balance plus $30,000 replacement loan) is more than the $28,000 maximum statutory loan amount.
If this loan was accepted in error, $18,000 (the difference between the $46,000 replacement loan and the $28,000 maximum statutory loan amount), would be a deemed distribution. Participant A would then receive an additional $12,000 and the new monthly payments would be $500.
NOTE: An employer may have the option to treat these two loans as separate loans, but that calculation is beyond the scope of this article. An employer should seek assistance from a competent tax professional when calculating loan refinancing.
Loan Reamortization vs. Loan Refinancing
Loan reamortization is often confused with loan refinancing, or incorrectly used as a synonym. Loan refinancing is considered a new loan, so all existing loan requirements are reevaluated. Loan reamortization; however, is not considered a new loan. It is a modification of an existing loan. So all the existing requirements remain the same. Generally, this also includes the original repayment amount—unless the employer changes its payroll frequency. Then, reamortization is needed to align the repayments with the new payroll schedule (which could reduce the total repayment amount). Loan reamortization is a corrective measure commonly used to correct loan failures, but loan refinancing is generally available at any time—not just as a corrective measure.
NOTE: Generally, other loan failure corrective measures under the Employee Plans Compliance Resolution System (EPCRS) may include deeming a loan as a taxable distribution (without a distributable event) or a loan offset (with a distributable event); making a lump-sum repayment; or a combination of reamortization and lump-sum repayment.
Example 1: A participant takes a loan with bi-monthly payments starting January 1, 2026. The employer fails to start withholding repayments and the error is not caught before the loan is in default. The employer has elected a 60-day cure period (if a missed repayment is not made by the last day of the cure period, the loan is in default on that date). The employer elects to reamortize the loan, which extends the loan term (assuming the previous term was not the maximum permitted term). But because a loan reamortization is not a new loan, no other modification was made (e.g., the interest and bi-monthly repayment amount remains the same).
Example 2: Assuming the same scenario as in Example 1 except, plan permitting, the employer elects loan refinancing. Because this is considered a new loan (and we assume that the loan requirements have been satisfied), the employer extends the term to the maximum permitted term for the original loan (replaced loan) and the bi-monthly repayment amount is reduced. Other simultaneous modifications may also be possible, depending on circumstances.
NOTE: If actively employed, a cure period is an optional grace period used to make up a missed repayment amount by no more than the end of the calendar quarter following the calendar quarter with the missed repayment (or less, if elected). If the employee has terminated, the employer can generally elect a 60-day or less cure period, starting from the termination date.
