Participant Loans

Benefits Of Participant Loans Participant loans from a Retirement Plan can be an attractive plan feature, allowing participants to access their benefit and then repay and restore it later. Note, however, that participant loans are rarely permissible under a defined benefit plan. However, to avoid being taxed as a distribution and other negative tax consequences, the plan loan program must be carefully structured to ensure that:

• Loans are available on a reasonably equivalent basis to all plan participants
• The plan document, or a separate written document, contains the terms of the loan program
• All loans bear a reasonable rate of interest
• Each loan is adequately secured

A reasonable rate of interest is generally considered to be the rate charged for a similar loan by a bank or other financial institution. The total of all plan loans must be the lesser of:

• One-half of the lump sum value of a participant's vested accrued benefit (or $10,000, if greater, as long as the participant provides additional security for the loan), or
• $50,000 reduced by the repaid loan amount in the past 12 months. The “repaid loan amount“ is the highest outstanding balance in the prior 12-month period minus the outstanding loan balance on the date of the new loan.

Participant Loans: Terms The written loan program should include the following provisions:

• The name of the person administering the loan program
• An explanation of the application process
• The basis on which loans will be approved or denied
• Limitations on the type and amount of loans offered under the plan
• The procedure for determining the applied interest rate
• The types of collateral that may be used
• The events that constitute default

The length of the loan may not exceed five years unless the loan is being used to purchase the participant's primary residence. For an HR Generalist, coordinating these terms is a key part of human resources compliance.

Procedural Recommendation: The following process can be used for a participant requesting and receiving a plan loan.

• Participant completes loan application
• Loan is reviewed by loan committee
• If approved, loan is forwarded to the investment committee
• Loan is approved or denied by loan committee
• If approved, the amortization schedule and loan terms are reviewed by participant
• Loan paperwork is signed
• Check is forwarded to participant

Participant Loans: Loan Re-Payments The Tax Code requires that payments be made in equal amounts at least quarterly. If loan payments are not made on a timely basis, the loan will be considered in default under labor law. Generally, there is a “cure period“ that expires at the end of the quarter following the quarter in which a loan payment is missed. (Note, however, that the “cure period“ may be shorter, depending upon the Plan's terms or the terms of the Plan's loan policy.) If the missed payment is not paid within the cure period, the loan will be in default and deemed a taxable distribution to the borrower. Note, however, that most loan programs are designed to pay the loan back via payroll withholding, adhering to FLSA guidelines for wage deductions. This will guarantee that, while the participant is an active employee, the loans will be repaid and there is no chance of default. When a loan is defaulted, the defaulted loan becomes taxable as income to the participant. If the participant has not attained age 59½, the amount of the defaulted loan is also subject to a 10% penalty tax. Even if the loan amount becomes taxable, it must be repaid to the plan account. After the default, repaid loan payments are treated as after-tax voluntary contributions (they are not tax deductible or excludable by the participant, however they are not taxed again when they are later distributed). The loan's promissory note usually states that the loan amount is payable immediately upon termination of employment. If a participant terminates employment with a loan outstanding and does not repay the loan, then the participant's vested accrued benefit will be reduced by the outstanding loan amount. The loan balance is considered distributed and is taxable as income. Note that, under the CARES Act discussed above, plans must permit loan payments due from a “qualified participant“ from March 27, 2020 through December 31, 2020 to be deferred for up to one year. This applies to any payment on any existing or new loan, although interest continues to accrue. The delayed payments, plus interest, must be paid by the end of the loan term (using re-amortization, balloon payments or periodic payments).

Administrative Tip: The plan sponsor usually establishes a loan program so that payments are made through payroll withholding, and thus minimizing defaults. The sponsor should go over the possible tax consequences with loan applicants so that the applicant knows the results of default. All financial and medical hardship data should be handled according to HIPAA privacy standards.