Managing the Use of Plan Loans

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).

Responsibilities

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:

• Evidence of the loan application, review, and approval process
• An executed plan loan note
• If the loan is for buying or constructing a primary residence, documentation verifying that the loan proceeds were used for that purpose
• Evidence of loan repayments
• Evidence of collection activities for defaulted loans, if any

Curbing Enthusiasm

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:

• Loan repayments are made with after-tax money
• Income taxes are paid again on distributions
• It may be difficult to save for retirement and pay back a loan at the same time
• Generally, loans must be paid back when the employee leaves
• If the loan is not repaid, the outstanding balance is treated as a taxable withdrawal subject to income tax and a possible 10% tax penalty

Additionally, sponsors may want to consider amending their plans to provide for some or all of the following:

• Limiting the number of loans participants can have outstanding at one time
• Implementing a waiting period between loans
• Not permitting borrowing from employer contributions
• Not allowing employees to refinance loans
• Restricting the loans to specified purposes only
• Making loans available only to active employees and not to terminated participants or plan beneficiaries

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.