Participant Loans: When Is a Loan Not a Loan?
Just as with hardship distributions, it’s up to plan administrators to ensure that participant loans are in full compliance with IRS and DOL regulations, and that the loan process is thoroughly documented. Failure to do so can result in the loan being treated as a distribution, triggering tax consequences for the participant.
Specifically, plan loans that do not meet legal requirements are considered to be a deemed distribution. This may happen when a participant fails to make a regularly scheduled loan payment or terminates employment and must repay the loan all at once. In both cases, the remaining loan balance is deemed to be a distribution and is subject to income tax, as well as the 10 percent penalty tax on early distributions if the participant is under age 59½.
The Best Defense
Usually, the best defense against compliance errors is a good offense. Working with their TPA, plan administrators must ensure that the following requirements are met:
Have a signed loan agreement on file. IRS rules state that without a signed loan agreement, the loan will not be considered a “legally enforceable agreement.”
Charge a reasonable interest rate. A plan loan must bear a “reasonable rate of interest.” The IRS says it generally considers “prime plus 2 percent” to be reasonable. However, plan sponsors may be successful in arguing that a lower interest rate is reasonable as long as the participant can obtain a loan on the open market with a similar lower interest rate.
Establish repayment terms. Plan loans must generally be repaid within five years, with participants making regular loan repayments at least quarterly. That said, nothing precludes plan sponsors from adopting a shorter repayment period, such as two or three years.
Plan sponsors may also allow participants to choose their repayment term as long as it is determined at the loan inception, and the term is no longer than five years (unless for the purchase of a primary residence). In practice, loan repayment for a primary residence is often 10 years.
Establish a Cure Period
A “cure period” is the period during which a participant can make up a loan payment in the event he or she misses a regularly scheduled payment. Treasury regulations allow plans to provide that a participant has until the end of the calendar quarter following the quarter in which the repayment was missed to make up the payment. However, a plan is not required to have a cure period and may also adopt a cure period shorter than the maximum cure period outlined above.
According to the IRS, plan sponsors 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.
- Documentation verifying that the loan proceeds were used to purchase or construct a primary residence, if applicable.
- Evidence of loan repayments.
- Evidence of collection activities for defaulted loans and related Forms 1099-R, if applicable.
Note that sponsors need to be sure that any service providers used to process loan requests have adequate controls and record-keeping in place. This can be evidenced by SSAE 16 audit reports.
Ultimately, a plan sponsor is not required to include loan provisions in its plan. But if you do, make sure such provisions are spelled out in plan documents and that processes are followed.