401(k) Participant Loans and Prohibited Transactions

Because a participant in a qualified plan (such as a 401(k) plan) is a “party in interest which 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:

• Be available to all plan participants and beneficiaries on a reasonably equivalent basis;
• Not be made more readily available to highly compensated employees, officers, or shareholders than they are to other employees;
• Be made in accordance with specific provisions set forth in the plan;
• Be adequately secured; and
• Bear a reasonable rate of interest (see below for more details).

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:

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.

• Plans must also have a set of legally enforceable loan procedures which typically go above and beyond the limited plan language setting forth the general participant loan program. Download sample Loan Policy and Procedures

• Participant loans must be applied for and executed by means of a legally-enforceable loan application and agreement. This loan application and agreement is made by the participant and is approved by a plan fiduciary, often the plan Trustee.

• If the plan and participant loan procedures so provide, more than one loan may be outstanding at one time. However, under the Code rules, a participant’s total loan limit for all loans under the plan is restricted to:
  • $50,000; or
  • 50% of his or her account balance, whichever is less. This means, for example, that you are not eligible for a $50,000 loan if your account balance is not $100,000 or more.

• The loan repayment schedule for general loans (i.e., loans made for purposes other than for a primary residence) must be no longer than five years, and must be amortized over such five-year (or less) period.

IMPORTANT: The Consolidated Appropriations Act of 2021 (“CAA”) temporarily increases the above limits for loans made during the 180-day period beginning on December 27, 2020 and ending on June 25, 2021 for loans made to “qualified individuals.” During this time period, (i) $100,000 is substituted for the regular $50,000, and (ii) “100 percent of the account balance is substituted for 50 percent.

For these purposes, a “qualified individual” is any individual (i) whose principal place of abode during any qualified disaster (such as the global COVID-19 pandemic) is located in the qualified disaster area; and (ii) who has sustained an economic loss by reason of such qualified disaster.

See Year-End Stimulus Act Effectively Extends CARES Act 401(k) Provisions for more details.

IMPORTANT: If a plan loan repayment is due between the first day of the incident period of a “qualified disaster” (such as the global COVID-19 crisis) and 180 days following the last day of such incident period, then the CAA 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 original repayment date (including any interest that accrues during that delay). The one-year delay is disregarded for purposes of the generally applicable five-year limit on loan repayments. See Year-End Stimulus Act Effectively Extends CARES Act 401(k) Provisions for more details

• Loan repayments must evenly spread out, and must be made no less frequently than once per quarter. Repayment schedules consisting of semi-annual payments, annual payments, or any repayment schedule having a “balloon payment” at the end of the term, are prohibited. In practice, many loans are repaid through payroll deductions, in which case this repayment requirement would automatically be met (assuming a normal payroll schedule of regular weekly, bi-weekly, semi-monthly or monthly pay periods).
• There may be no pre-payment penalties associated with participant loans.
• The loan interest rate must be “reasonable.” Under official DOL guidance, an interest rate is considered to be reasonable if it is equal to commercial lending interest rates under similar circumstances.

• • The DOL has provided the following example of a determination of a reasonable interest rate for this purpose: “The trustees, prior to making the loan, contacted two local banks to determine under what terms the banks would make a similar loan, taking into account the plan participant’s creditworthiness and the collateral.”
  • Although, in practice, many plans use the current prime interest rate (at the time the loan is taken out) plus one percent, it should be noted that the DOL has not established such as an approach as a “safe harbor.” So far, however, we are aware of no plans that have been challenged for using a “prime plus one” approach.

• If actual practice shows a pattern, or an unusually high incidence, of unpaid loans, either the DOL or the IRS may take the position that the plan loan program is not a bona fide participant loan program under the statutory exemption. Accordingly, loans received by participants under such a non-exempt program would constitute prohibited transactions, thereby subjecting both the plan and participants to potential penalties (see below).
• A plan is permitted to require a participant to repay the full outstanding balance of a loan if he or she terminates employment, or if the plan is terminated prior to full pay-off of the loan. If the participant is unable to repay the full balance of the loan, then the plan sponsor must treat the unpaid portion of the loan as a distribution, and report it to the IRS on Form 1099-R. (See Loan Offsets below)
  • The participant generally can avoid the immediate income tax consequences of the distribution by rolling over all or part of the loan’s outstanding balance to an IRA or eligible retirement plan within the proper period (See Loan Offsets below)

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.

For information on rollovers of “qualified loan offsets,” see IRS Releases Final Regulations on Rollovers of 401(k) Qualified Plan Loan Offsets.