Offering loans from qualified plans, Make sure your participants understand the fine print.

Posted on Wednesday, September 07, 2005

Abstract: Many qualified plans allow participants to borrow from their retirement assets and repay the amount with interest to their own accounts. Trouble is, those who do so often understand neither the rules nor the ramifications of the transaction. This article explains what plan administrators should tell their participants about the fine print of qualified plan loans.

Offering loans from qualified plans

Make sure your participants understand the fine print

Although most participants don't intend to take money from their retirement plans until after they retire, circumstances in their lives may leave them with no alternative. Many qualified plans allow participants to borrow from their retirement assets and repay the amount with interest to their own accounts. Trouble is, those who do so often understand neither the rules nor the ramifications of the transaction. Why do it? The benefit of taking a loan from a qualified plan is that, as mentioned, the interest is repaid to the employee's own account rather than a financial institution. The money is also quickly and easily accessible - participants need not go through a lengthy approval process. The downside is that assets removed from an account as a loan lose the benefit of earnings growth. Also, the amounts used to repay the loan come from after-tax assets, meaning the employee has already paid taxes on these amounts once and will do so again after removing the assets from the plan. What are the rules? Regulations permit - but don't require - qualified plans to offer loans. Some plans allow loans only for what they define as hardship circumstances, such as:

• The threat of being evicted because of an inability to pay rent or mortgage,
• The need to pay for uninsured medical expenses,
• The onset of higher education expenses for the participant or a family member, or
• The opportunity to buy a principal residence.

Generally, qualifying for a loan based on hardship circumstances requires participants to prove that they've exhausted certain other resources. On the other hand, some plans are much more liberal about dispersing loans. They may allow employees to borrow from the plan for any reason without disclosing the loan's purpose. Is there a maximum? A qualified plan must operate loans in accordance with government regulations, one of which is a restriction on the maximum loan amount. It stipulates that participants may borrow only 50% of the vested account balance or $50,000, whichever is less. Plans are allowed to make an exception to this dollar limit if 50% of the vested balance is less than $10,000, in which case the maximum the employee can take out is $10,000. But few plans make this allowance because of the requirement that the sponsor obtain additional collateral for the loan. How about repayments? Generally, participants must repay qualified plan loans within five years. You may allow an exception if the borrower is using the loan to buy a primary residence. As plan sponsor, either you or your third party administrator must prepare an amortization schedule that provides the repayment schedule and repayment amount with interest for any loans from your qualified plan. Repayments are usually set according to the employee's pay schedule, but you could set them as far apart as quarterly. The IRS may consider loans that don't meet regulatory requirements as "deemed distributions." For instance, if loan repayments aren't made at least quarterly, the remaining balance is treated as a distribution that isn't rollover eligible but is subject to income tax as well as a 10% early withdrawal penalty if the participant is under age 59. If an employee continues to participate in the plan after a deemed distribution occurs, he or she still has the loan obligation. These amounts are treated as after-tax contributions and won't be taxable when distributed. Do exceptions ever apply? Repayment terms are subject to some exceptions. If an employee is in the armed forces, his or her repayments may be suspended for at least the period of active duty. The loan repayment period is then extended by the duration the participant was on active duty. If, during a nonmilitary leave of absence, an employee's salary is reduced to the point at which it's insufficient to repay the loan, the employer may suspend repayment up to a year. Unlike the exception for active members of the armed forces, this loan repayment period is not extended because of the participant's leave of absence. Instead, he or she may have to increase the scheduled payment amounts to pay off the loan in the original time frame. Have you said enough? If employees know they may draw qualified plan loans, their willingness to participate in a 401(k) plan may increase. Nonetheless, be sure to stress that loans should be used only as a last resort. Some participants may not understand that withdrawing their funds can - and often does - dramatically affect the borrower's tax liability and retirement savings.

Sidebar: Loan policies are a good policy

Many qualified plans have a written policy governing the terms of plan loans. Common features of the plan document or loan policy include:

• Limiting participants to one outstanding loan at a time, and
• Setting a minimum loan amount of $1,000.

Establishing these additional requirements can reduce the administrative burden associated with multiple loans and those of small amounts. If your plan document doesn't include a loan policy, consider adding one. It can't hurt to clarify your stance with potential borrowers.