Qualified retirement plans, such as 401(k), 403(b), or 457(b) plans, may offer plan loan features, providing participants the ability to borrow from their account balance. As an employer, it is your choice to offer this option. If your plan does not currently allow participant loans, you can amend your plan document at any time to include the 401(k) loan feature.
Retirement plan loan programs are subject to the jurisdiction and requirements of ERISA and the IRS. These requirements are designed to protect participants from loan-related tax issues and the misuse of their funds. Those rules include a specific set of conditions that must be met to allow a participant to borrow money. If a plan fails to meet the statutory requirements, the plan fiduciaries could be held liable (including personal liability), and the participant could be subject to taxes and penalties. As intimidating as this may seem, understanding and following the rules doesn’t have to be that complicated.
Authorization of the participant loan program must be documented in the plan document. The actual loan program details must be documented in either the plan document or a separate loan policy document. If a separate loan policy document is created, it must be referenced within and distributed with the plan document. The availability of the loan program must be communicated to all participants to avoid being deemed as discriminatory.
When creating your loan program, there is flexibility, as long as the plan remains within the established ERISA and IRS parameters. Below are some of the choices to consider:
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Loan Purpose:
- Allow loans for all purposes.
- Allow hardship loans only.
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Frequency of Loans:
- One outstanding loan at a time.
- No more than five outstanding loans at one time.
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Frequency of Payments:
- Level (relatively equal) principal and interest payments must be made at least quarterly. It is common practice to match the payments to the payroll schedule.
- Level (relatively equal) principal and interest payments must be made at least quarterly. It is common practice to match the payments to the payroll schedule.
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Repayment Method:
- No specific requirement as long as the frequency parameters are met. Generally, payroll deduction is the simplest way and will help to ensure fiduciary compliance with timely repayment.
- Lump sum or partial repayments via bank transfer may be permitted.
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Loan Repayment upon employee’s termination:
- All loans are due and payable in full.
- All loans are due and payable in full as soon as the employee takes any withdrawal from their retirement plan account.
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Minimum Loan Amount:
- No minimum required ($1,000 minimum is typical. Higher can be deemed discriminatory, lower can cause excessive loans.).
- No minimum required ($1,000 minimum is typical. Higher can be deemed discriminatory, lower can cause excessive loans.).
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Maximum Loan Amount:
- Up to 50% of the employee’s vested balance not to exceed a total of $50,000 for all outstanding plan loans. (An employee with a vested balance of $200,000, even though 50% is $100,000, would still be limited to $50,000 per IRS rules).
- Up to 50% of the employee’s vested balance not to exceed a total of $50,000 for all outstanding plan loans. (An employee with a vested balance of $200,000, even though 50% is $100,000, would still be limited to $50,000 per IRS rules).
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Length of Loan:
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All loans must be repaid with five years, except for loans used to purchase a primary residence. You can specify the number of years, up to a maximum of 30, for a home purchase loan.
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Once your loan program is in place, you should periodically review the loan policy to ensure that the rules for plan loans are accurate and in accordance with ERISA and the IRS regulations.
Generally, the plan’s third-party administrator (TPA) handles loan transactions, but the plan sponsor is ultimately responsible. The plan sponsor should verify that the TPA has a process to request and retain the required loan documentation.
Below is a list of documents that are needed and should be retained for each plan loan based on IRS issued guidance in 2015:
A plan sponsor should retain these records, in paper or electronic format, for each plan loan granted to a participant:
- Evidence of the loan application, review, and approval process
- An executed plan loan note
- If applicable, documentation verifying that the loan proceeds were used to purchase or construct a primary residence.
- Evidence of loan repayments
- Evidence of collection activities associated with loans in default and the related Forms 1099-R, if applicable.
IRS audits have found that some plan administrators impermissibly allowed participants to self-certify their eligibility for these loans.
As you can see from the overview above, establishing a loan program can be complex. Once the details are established and documented, following the program should be reasonably straightforward. Offering loans to participants can help them avoid taking a distribution in a time of need. Money taken as a distribution would be taxed and cannot be returned to the plan. Loans are not taxed, and the money is repaid to the plan and where it can continue to grow. If you have any questions about loans or plan design, contact one of our retirement plan advisors today.