Tax Article - Qualified Plan Loans: What You Don’t Know Can Hurt You

Among the risks of offering workers a “qualified” retirement plan (one that follows certain rules to qualify for beneficial tax treatment), such as a 401(k), is that the arrangement may allow participants to take loans from their accounts. Although employees often appreciate this feature, taking out a qualified plan loan can get workers into trouble — and hurt your company as a whole.

Some choices are yours …

For starters, you don’t necessarily have to give employees the option of being able to take out loans from their qualified plans. If you do want to make this option available, your plan document must be drafted to allow it. Your plan also needs to specify the rules for loans, including:

• The minimum and maximum loan terms,
• The number of loans available, and
• Sources of funding available for loans (such as salary deferrals or employer matching).

Your plan may specify that participants can take loans only in the event of a hardship as recognized by IRS safe harbors. These include medical expenses, higher education, impending home foreclosures, funeral expenses or natural disasters. Or your plan may specify a hardship using facts and circumstances that you determine.

… and some are not

If you do decide to offer plan loans, you must do so within IRS rules. For starters, you must make loans available to all participants equally — your plan can’t favor highly compensated employees.

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In addition, loans must bear a reasonable rate of interest. Often, plan sponsors state that the loan interest rate follows the current prime rate or prime plus 1%. The loan terms can’t extend beyond five years, unless the loan is for the purchase of a principal residence. In that case, participants may take longer (up to 30 years) to repay.

Generally, qualified plans may allow a participant to take out a loan of up to 50% of his or her vested balance or $50,000, whichever is less. This amount may be reduced by the amount of other outstanding loans the participant has against the plan. The calculation for determining this is complex; ask your plan administrator for details.

Plan loans also must be secured. This means, preferably, you or your plan administrator should obtain a signed promissory note with a pledge and assignment along with an additional sign-off on an authorized payroll deduction.

Moreover, loans need to provide for a level amortization schedule — not a “balloon” payment after a term of years. Generally, participants should make principal and interest payments at least quarterly. (An exception may apply to those on military leave or those absent under the Family and Medical Leave Act.)

Taxable events threaten

If a participant fails to meet the loan terms or the statutory requirements, the IRS will view the loan as a “deemed distribution,” which is a taxable event. Thereby, the participant will be taxed on the loan amount at his or her current tax rate as if a distribution had been made.

If structured to do so, some qualified plans may permit a “cure period” to resolve outstanding loans. But such a period can’t be longer than one calendar quarter following the quarter in which the violation occurred.

A deemed distribution may also occur if your plan document doesn’t allow for a participant’s account balance to offset the loan. If a loan offset is allowed in the plan document, such a distribution is considered a qualified rollover event.

The risks are many

This article only scratches the surface of some of the complex rules governing qualified plan loans. The bottom line is that offering these loans to your employees without fully understanding the rules — and educating participants on those rules — could hurt plan participation, lower morale and threaten productivity.

3 fair warnings to your employees

The large sums that workers can amass in a qualified retirement plan, such as a 401(k), can tempt them to take out loans without fully understanding the rules. Here are three “fair warnings” you can provide:

1. Loans inhibit growth. Less invested means less potential compounded growth — even though the account will receive interest income from the employee. And less compounded growth could force an employee to postpone retirement or scale back on future plans. If all scheduled loan payments are made, the loan will perform similarly to a bond rather than an equity investment.

2. Taxes aren’t the only threat. If a participant who is younger than 591/2 fails to repay the proceeds within the time period provided, he or she will not only have to pay income taxes on the loan amount, but also may owe an additional 10% early withdrawal penalty. Thus, depending on his or her tax bracket, an employee could owe federal taxes equal to as much as 45% of the funds borrowed — a steep price to pay. State taxes will add even more in some states.

3. Leaving the company could speed up the due date. This last point may be a little awkward to bring up, but many qualified plans are set up so that departing participants must pay back any outstanding loans within 30 to 90 days of leaving. This is done because there’s no longer payroll from which the plan can get automatic payments. If this is true for your plan, be sure your employees are aware of it.

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