401(k) Participant Loans and Prohibited Transactions


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Because a participant in a qualified plan (such as a 401(k) plan) is a “party in interest Tooltipwhich is also known as a “disqualified person” under the Internal Revenue Code under ERISA, a loan between a 401(k) plan and a participant under such plan would constitute a “prohibited transaction” with respect to the plan. Accordingly, participant loan programs, which are a common feature under 401(k) plans, would not be possible unless there were a statutory or other exemption from the prohibited transaction rules.

Fortunately, the law statutorily exempts certain transactions, including participant loans that meet certain requirements, from being prohibited transactions. Assuming all of the pertinent requirements are met, a loan between a 401(k) plan and a participant in the plan pursuant to such loan program would not constitute a prohibited transaction under ERISA or the Code, nor necessitate any corrective action that otherwise would be warranted.

DOL Conditions For Meeting The Statutory Exemption

The U.S. Department of Labor (DOL) generally has jurisdiction for enforcing the ERISA prohibited transaction rules. Under official DOL guidance, in order to meet the conditions of the statutory exemption, loans to 401(k) plan participants generally must:

Internal Revenue Code and Treasury Regulation Requirements

Because the Internal Revenue Code (Code) also contains provisions that preclude prohibited transactions between qualified retirement plans and “disqualified persons,” the Code and U.S. Department of Treasury Regulations have their own set of rules that apply to 401(k) participant loan programs. This means that 401(k) plan loan programs also must meet these Code and regulatory requirements in order to avoid loans from being considered prohibited transactions under the Code. Generally stated, the rules are as follows:

DOL vs IRS

Because both the DOL and the IRS have jurisdiction over the prohibited transaction rules that apply to ERISA-covered, tax-qualified retirement plans, some of the IRS rules listed to the left are similar to, or overlap, the DOL rules cited in the previous section of this article.

The 401(k) plan document must explicitly authorize and permit participant loans from the plan. If the plan document does not contain fully compliant participant loan provisions, then the participant cannot take a loan from the plan (because such loan would not fit within the prohibited transaction exemption). These days, the overwhelming majority of 401(k) plans contain participant loan provisions.

IMPORTANT: If a plan loan repayment is due between March 27, 2020, and before the end of the calendar year 2020, then the CARES Act allows the repayment to be delayed for one year, measured from the original loan due date. Subsequent loan repayments must be adjusted to reflect the delay in the 2020 repayment (including any interest that accrues during that delay). The one-year delay for 2020 is disregarded for purposes of the generally applicable five-year limit on loan repayments. See “Congress Passes CARES Act in Response to COVID-19 Crisis Contains 401(k) Ease-of-Access and Other Provisions.”

What Happens If The Plan Loan Program Doesn’t Qualify For The Statutory Exemption?

Basically, any loan made between a 401(k) plan and a participant in such plan that does not meet the statutory exemption would constitute a prohibited transaction under both ERISA and the Code. Specifically, the loan would constitute “lending money or extending credit between a plan and a disqualified person [party in interest].” As such, the general Code and ERISA penalties and consequences applicable to prohibited transactions would apply to the entire amount of such loans.

Internal Revenue Code Ramifications. Generally stated, under the Code, a disqualified person who takes part in a prohibited transaction must correct the transaction (i.e., fully repay to the plan the amount of the loan), and also must pay an excise tax based on the amount involved in the transaction. The initial tax on a prohibited transaction is fifteen percent (15%) of the amount involved for each year (or part of a year) during the taxable period in which the transaction occurred.

If the transaction is not corrected within the taxable period, an additional tax of one hundred percent (100%) of the amount involved is imposed. Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax. The tax is paid by filing IRS Form 5330.

In certain limited circumstances, correction of a plan loan defect by means of the DOL’s Voluntary Fiduciary Correction Program (“VFCP”) effectively eliminates the prohibited transaction problem under the Code by means of a specific DOL class exemption. Pursuant to this special class exemption, plan loan failures that are corrected via VFCP are granted relief from the otherwise applicable prohibited transaction provisions of the Code.

Accordingly, plan loan failures that are corrected via VFCP are not treated as prohibited transactions under the Code, and are therefore not subject to the Code’s penalty taxes for prohibited transactions. However, VFCP covers only certain plan loan failures – for example, the making of a loan by a plan at a fair market interest rate to a party in interest with respect to the plan, defaulted loans, or loans failing to comply with plan provisions for amount, duration, or level amortization. Therefore, other plan loan failures – for example, if a plan makes participant loans where it does not have specific plan loan procedures, or if loans are not made in compliance with such plan loan procedures – would not be correctable via VFCP, and would, therefore, still constitute prohibited transactions, subject to Code penalties.

ERISA Ramifications. Importantly – and perhaps counterintuitively — no relief is provided from the prohibited transaction provisions of ERISA simply because such relief is provided under the VFCP. Therefore, ERISA sanctions applicable to prohibited transactions presumably would apply to all plan loan failures, even if they are corrected via VFCP.

Generally stated, ERISA requires a full, prompt correction of prohibited transactions. This means that the plan must be made whole, and the party or parties involved must disgorge any profits resulting from the transaction. This can get extremely complex in the case of plan loans that are deemed to be prohibited transactions; therefore, you are strongly urged to consult with ERISA counsel if you believe that this might apply to you or your plan.

Deemed Distributions

Although not strictly a prohibited transaction issue, in addition to potentially being treated as being prohibited transactions under the Code rules, participant loans that exceed the maximum permitted amount, or that do not follow the required repayment schedule, are considered “deemed distributions.” Such deemed distributions would be subject to regular income tax and may also be subject to the 10% penalty tax on early withdrawal, if the participant has not attained age 59 ½.

If the participant continues to participate in the plan after the deemed distribution occurs, he or she is still required to make loan repayments. However, these amounts are treated as “basis” and will not be taxable when they are later distributed by the plan.

Loan Offsets

If a participant should default on a loan — for example, due to one or more missed installment payments – the plan is permitted to distribute the amount of the unpaid loan balance in what is referred to as a “loan offset.” To effectuate a loan offset, the participant’s accrued benefit is generally reduced by the entire amount of the outstanding loan balance, in order to repay the loan and enforce the plan’s security interest. Importantly, a loan offset is an actual distribution from the plan (as opposed to a “deemed distribution” which is described above) — which means that the entire amount of the loan offset (i.e., the entire amount distributed) is taxable to the participant in the year in which it is received.

To avoid this immediate taxation on the amount of the loan offset, the amount generally may be “rolled over” by the affected participant into another qualified retirement plan or IRA. Because a plan loan offset only extinguishes the loan liability and does not result in the receipt of any actual funds, the money for a loan offset rollover must come from the participant’s other assets – assuming the participant no longer has the original loan proceeds. In other words, cash equal to the full amount of the loan offset – regardless of where the cash comes from — must be rolled over to another qualified retirement plan or IRA within in proper time period in order to accomplish the loan offset rollover.

To accomplish a “loan offset rollover,” normally the rollover must be completed by no later than 60 days following the date of distribution of the loan offset amount. However, there is an exception for “qualified plan loan offsets” (“QPLOs”). Generally stated, these are loan offsets made solely due to a plan termination or a participant’s severance from employment. For QPLOs, the deadline for making a loan offset rollover is extended until the due date, including extensions, for filing the participant’s federal income tax return for the taxable year in which the offset occurs.

Loan offsets are treated as plan distributions and must be reported to the IRS on Form 1099-R.