A plan loan feature can be a useful tool for helping to increase plan participation and contribution rates. Nevertheless, plan loans may impede employees’ efforts toward achieving their long-term retirement goals and complicate plan administration. Following is a general discussion of some of the issues surrounding plan loans and suggestions for addressing them.
Understanding the Rules
Two sets of rules must be complied with when a plan maintains a participant loan program — those under the pension law (ERISA) and the tax rules set forth in the Internal Revenue Code. Generally, ERISA rules provide that loans will be exempt from treatment as prohibited transactions if, under the plan, loans are available to all participants on a “reasonably equivalent basis,” are not made available to “highly compensated employees” in amounts greater than to other participants, are adequately secured, are extended at a reasonable rate of interest, and comply with the plan’s terms.
The Internal Revenue Code contains parallel prohibited transaction provisions. The income tax rules also provide that, generally, a loan from a qualified plan will not be treated as a taxable distribution if it must be repaid within five years (except for certain home loans) and doesn’t exceed the lesser of: (1) $50,000 or (2) the greater of (a) half the present value of the employee’s nonforfeitable accrued benefit under the plan or (b) $10,000. (The limits are somewhat different where an employee has more than one loan.) The tax law also requires that a loan be amortized in substantially level payments, at least quarterly, over its term. An exception applies while an employee is on unpaid leave for up to one year (or possibly longer for those in the uniformed services).
When a plan allows loans, plan sponsors should make sure they have appropriate procedures in place to keep track of each loan. In a broad sense, loan administration involves determining the right of the employee to take a loan, ensuring that the employee makes loan payments on a timely basis, and promptly identifying loan defaults. The IRS recommends that sponsors retain the following information for each plan loan:
To reduce the overuse of plan loans, sponsors may want to begin by educating participants about these potential disadvantages of taking loans from their retirement plan:
Additionally, sponsors may want to consider amending their plans to provide for some or all of the following:
Other options include increasing the loan origination fee or processing charges. If fees incurred by the plan to set up and administer loans are reasonable and permitted under the plan document terms, they may be charged to the participant’s account.
Giving participants the ability to take out a loan can reassure employees that they have access to their account assets if they need them. Taking some of the steps outlined here may prove helpful in discouraging employees from taking unnecessary plan loans.
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