When William Shakespeare wrote
"neither a borrower nor a lender be," he probably never envisioned a world
in which millions of people could be both borrower and lender of their own
retirement funds. Nor could he have anticipated that such loans would be
available at extremely reasonable interest rates and without even an ounce
of flesh as collateral! With all due respect to the great playwright, even
the most profound and well-accepted adages need to be reevaluated in our
rapidly changing society.
With the increased popularity of defined contribution plans, more plans
are providing participants with the option of borrowing from their
retirement accounts, especially 401(k) accounts, which are funded by their
own salary deferrals.
There are a number of reasons why borrowing from a retirement account is
a good idea. With interest rates at their lowest level in years, the cost of
the loan is relatively inexpensive. In plans with individually invested
accounts, the loan repayments are credited directly to the participant's
account. That means the account will own an investment with a guaranteed
rate of return equal to the loan interest rate. With the recent uncertainty
in the stock market and the extremely low rates being offered in fixed
income investments, a loan with an interest rate above prime might be a
welcome investment. Repayments are usually simplified through automatic
salary reductions. Lastly, a plan loan may be easier to obtain than one at
the local bank, since the accrued benefit may be the only collateral
necessary.
In December of 2002, the IRS issued final loan regulations. What follows
is an explanation of the final regulations along with the general
requirements for retirement plan loans.
Prohibited Transaction Issues
Under ERISA and the Internal Revenue Code, transactions between a plan
and a disqualified person are considered prohibited transactions.
Disqualified persons include plan participants. There is an exemption for
plan loans to participants if all of the following conditions are met:
- The plan must allow for loans and they must be available to all
participants on a reasonably equivalent basis.
- The plan's loan policy must not discriminate in favor of employees who
are considered "highly compensated."
- The loan must be adequately secured.
- The loan must bear a reasonable rate of interest.
If any of these requirements are not met, a plan loan will be considered
a prohibited transaction subject to excise taxes and corrective procedures.
A plan that is subject to the survivor annuity requirements must also
require spousal consent for loans to married participants that are secured
by the participants' accrued benefits, unless the accrued benefits are
$5,000 or less. Without it, the loan will not be considered adequately
secured.
The participant loan exemption previously did not apply to sole
proprietors, partners owning more than 10% of a partnership and shareholders
owning more than 5% of an S corporation. However, those restrictions were
lifted by the Economic Growth and Tax Relief Reconciliation Act ("EGTRRA")
in July 2001, effective for plan years beginning after December 31, 2001.
Loan Requirements and Limitations
In addition to the prohibited transaction rules, plan loans must meet the
following requirements and limitations:
Dollar Limit
When calculating the dollar limit for a plan loan, all qualified plans of
an employer, including employers who are related in a controlled group or an
affiliated service group, are treated as one plan. A retirement plan loan,
when added to the outstanding balance of all other loans under the plan,
cannot exceed the lesser of $50,000 or 50% of the participant's present
value of vested benefits. The $50,000 ceiling is reduced by the amount that
the highest outstanding loan balance during the previous year exceeds the
current outstanding loan balance. In addition, if the plan permits, a loan
for up to $10,000 can be made even if it exceeds 50% of the participant's
vested benefits, as long as it does not exceed 100% of such vested benefits.
To the extent that it does exceed 50% under this provision, additional
collateral is required, since no more than 50% of the participant's vested
benefits can be used as security for a loan.
Example
As of January 1, 2003, Derek had an outstanding loan under his employer's
401(k) plan of $20,000, with total vested benefits of $100,000 ($80,000 in
mutual funds, and $20,000 payable under the loan note). He wanted to take a
second plan loan on that date. If Derek borrowed an additional $30,000, his
new total loan balance would be $50,000, which equals the dollar limit and
is exactly 50% of his vested benefits.
However, his highest outstanding balance during the previous 12 months
was $28,000 (the January 1, 2002 balance). Since this amount exceeded the
January 1, 2003 loan balance by $8,000, the $50,000 limit is reduced to
$42,000. Consequently, Derek would be limited to a new loan of $22,000
($42,000 - $20,000). Any amount above that level would be taxed as a "deemed
distribution."
Term of the Loan
Retirement plan loans must be repaid within five years, unless the loan
is for the purchase of the participant's principal residence, in which case
it can be repaid over a longer period. The loan must be repaid pursuant to a
level amortization schedule, which provides for both principal and interest
payments no less frequently than quarterly.
Leave of Absence
A plan may allow a participant to cease loan repayments during a bona
fide leave of absence of up to one year, either without pay or at a rate of
pay (after taxes) that is less than the required loan payment. However,
repayments must continue after the year is up, whether or not the leave of
absence is over, and the loan must be fully repaid by the latest permissible
term of the loan.
The participant can increase the amortized payments to make up for the
missed payments, plus interest, or make a balloon payment at the end of the
term. Loans originally established for less than the maximum permissible
term can be extended up to the permissible term limit, but payments due
after the allowable absence period cannot be less than the payments due
under the original amortization schedule.
Military Leave
A plan may suspend required loan repayments during a period of military
service, even if it lasts beyond one year. The final regulations state that
interest will continue to accrue during the leave, but at a rate not in
excess of 6%. Upon return, the loan payments must continue, but the final
due date is extended by the length of the military leave of absence.
The participant can either increase the payments to pay off the interest
that accrued during the military service, or pay it as a balloon payment at
the end of the term. In addition, loans which were originally for a period
of less than five years can be extended after military service so that the
total term is up to five years plus the length of the military service. This
is allowable even if it results in a reduction of payments from the original
amortization schedule.
Example
Adrienne Do-Right volunteered for military service on April 1, 2001. At
that time she had an outstanding loan from the XYZ Company 401(k) Plan that
she had taken out on July 1, 2000, to be repaid by July 1, 2003 (three-year
term). Adrienne expects to return to work for the XYZ Company on April 1,
2003, having missed two years.
She can resume the same loan payments until July 1, 2005, at which time
she can make a balloon payment of two years worth of interest that accrued
during her military leave (using the interest rate of the loan, not to
exceed 6%). Alternatively, she can increase all of her remaining payments by
the amount necessary to pay the additional accrued interest.
As a third option, she can revise the repayment schedule by extending the
term of the loan two years (in addition to the extension for the leave) to
July 1, 2007, since her original term was for three years instead of the
allowable five years.
Loan Refinancing
If permitted by the plan, loan refinancing occurs when a participant
replaces one loan with another. This might occur due to a change in interest
rates or in the case of a participant who wants to increase the amount of
his loan and the plan does not permit more than one loan.
Generally, the prior outstanding loan should continue to be repaid over a
period no longer than the longest allowable term of the initial loan
(generally five years unless a principal residence loan). Therefore, if the
refinanced loan will be paid back within five years from the date of the
original loan, the repayment requirements will be satisfied.
If any portion of the refinanced loan has a later repayment date than the
original five-year period, the refinancing may result in a deemed
distribution. An exception applies if a replacement loan contains two parts:
one that refinances the original loan within its allowable term, and another
that establishes a new loan to be amortized within the allowable term of the
replacement loan.
Deemed Distributions
There are a number of circumstances which result in a loan being
considered a deemed distribution. Loans that do not initially meet all of
the statutory requirements will be taxed as deemed distributions. Once the
loan has been issued, a deemed distribution will occur if a scheduled
payment is missed. The loan is considered in default and the outstanding
balance becomes the amount of the deemed distribution.
A plan may provide for a "cure" period during which the participant can
make up the missed payment. Such cure period is acceptable if it does not
extend beyond the calendar quarter following the quarter in which the missed
payment occurred. A deemed distribution is taxable to the participant in the
calendar year in which it occurs and is subject to a 10% penalty tax if the
participant is under age 59½.
For purposes of determining the maximum amount of any subsequent plan
loan, a deemed distribution that has not been repaid or offset (plus accrued
interest) is still considered in effect and outstanding. If the loan is not
repaid or offset, then subsequent loans will be taxable unless one of the
following additional requirements are met:
- The participant enters into an enforceable agreement under which
repayments will be made through payroll withholding, or
- The participant provides additional security for the new loan other
than the accrued benefits under the plan.
Effective Date
The 2002 final loan regulations are effective for loans made from
qualified plans after December 31, 2003. In the meantime, a reasonable, good
faith compliance standard applies. The final regulations do not apply to
loans made under certain insurance contracts that are in effect on December
31, 2003.
Conclusion
It is no surprise, given the current state of our economy, that
participant loans from qualified plans are gaining in popularity. They
provide a convenient way for employees to access their own funds in time of
financial need, while also gaining a secure and competitive rate of return
on their retirement investments. While there are still many rules that need
to be followed, a properly administered loan program can be a valuable
benefit to retirement plan participants.
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