401(k) Plan Loans

If the plan allows participant loans, it is important to know that the IRS and DOL are focused on ensuring that participants continue to make their loan repayments in a timely manner and that loans are processed according to the ERISA code (Section 72(p)) dealing with this plan provision.

A DOL examiner or investigator will want to examine outstanding plan loans to ensure all loans are properly documented, and loans are being serviced in a manner consistent with the above-referenced code section and the plan’s Loan Agreement document.

IRS Guidelines

A plan loan policy may include constraints or requirements that exceed the provisions set by the IRS. Key points associated with the IRS guidelines for offering participant loans are listed below.

• The maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of the participant’s vested account balance, or (2) $50,000, whichever is less.
• A participant may have more than one outstanding loan from the plan at a time. However, any new loan, when added to the outstanding balance of all of the participant’s loans from the plan, cannot be more than the plan maximum loan amount. In determining the plan maximum loan amount, the $50,000 is reduced by the difference between the highest outstanding balance of all of the participant’s loans during the 12-month period ending on the day before the new loan and the outstanding balance of the participant’s loans from the plan on the date of the new loan.
• A plan may require the spouse of a married participant to consent to a plan loan.
• A plan must specify the procedures for applying for a loan and the repayment terms for the loan.
• Repayment of the loan must occur within five years. Payments must be made in substantially equal payments that include principal and interest and paid at least quarterly.

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 Consolidated Appropriations Act of 2021 (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 (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 details.

• Loan repayments are not plan contributions.
• A loan that is taken for the purpose of purchasing the employee’s principal residence may be able to be paid back over a period of more than five years.
• A plan may suspend loan repayments for employees performing military service.
• A plan also may suspend loan repayments during a leave of absence of up to one year. However, upon return, the participant must make up the missed payments either by increasing the amount of each monthly payment or by paying a lump sum at the end, so that the term of the loan does not exceed the original 5-year term.
• Loans are not dependent upon hardship. Some plans may provide for hardship withdrawals, which require a demonstration of need. However, the purpose of a loan or the participant’s ability to borrow the same amount elsewhere is irrelevant in determining whether a loan is permitted.
• The participant’s relationship to the plan (e.g., being an owner of the plan sponsor) does not affect the participant’s ability to take a loan, as long as all participants are equally able to take loans under the plan’s loan provisions.
• Loans are not taxable distributions unless they fail to satisfy the plan’s loan rules or the regulations with respect to the amount, duration, and repayment terms, as described above. Also, a loan that is not paid back according to the repayment terms is treated as a distribution from the plan and is taxable as such.

For additional information on this subject, please contact your plan’s ERISA attorney. The IRS web site has additional information on participant loans.

Legally Enforceable Agreement

The loan documents may be paper or electronic documents stating the date and amount of the loan and binding the participant to a repayment schedule.  The loan must be adequately secured (typically by the participant’s account balance), and a reasonable rate of interest must be charged to the participant.

The Internal Revenue Service has stressed that the plan sponsor (and not a third party administrator) is ultimately response for retaining the following documentation on all plan loans, either in paper or electronic format:

• Evidence of the loan application, review, and approval process;
• An executed plan loan note;
• If applicable, documentation verifying that the loan proceeds were used to purchase or construct a primary residence;
• Evidence of loan repayments; and
• Evidence of collection activities associated with loans in default and the related Forms 1099-R, if applicable.

Maximum Loan Amount

The maximum amount a participant may borrow from a 401(k) is 50% of the participant’s vested account balance or $50,000, whichever is less.  This may include more than one loan under the plan, unless the plan loan rules restrict the number of plan loans.  However, if the participant previously took out another loan, the $50,000 limit is reduced by the highest outstanding loan balance during the one-year period ending on the day before the new loan is distributed.  The practical effect of this rule is to limit a participant’s total principal amount of plan loans to $50,000 during any 12-month period.

IMPORTANT: The 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.

Note:  There is a permanent exception which allows loans up to $10,000, even if the loan amount exceeds 50% of the participant’s vested account balance.  However, because a loan may not be secured by more than 50% of the vested account balance, additional collateral would be required to provide adequate security for the loan.  Because most 401(k) plans do not provide for security outside of the vested plan accounts, it is not common for a 401(k) plan to include this exception for loans up to $10,000.

Examples:

Bill has a vested account balance of $80,000. Bill may take a loan up to $40,000, which is the lesser of 50% of his vested account balance and $50,000.

Sue has a vested account balance of $120,000. Sue may take a loan up to $50,000, which is the lesser of 50% of her vested account balance of $120,000 ($60,000) or $50,000.

Reasonable Interest Rate

The 401(k) plan must provide for a reasonable rate of interest which should be similar to what a participant might expect to receive from a financial institution for a similarly secured loan.

Repayment Period

Generally, the participant must repay a plan loan within 5 years and must make level payments at least quarterly. The law provides that a 401(k) plan may (but is not required to) include an exception to the 5-year requirement if the participant provides documentation proving that the loan is being used to purchase a primary residence.

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 (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.

Most plan loan payments are made through payroll withholding and are based on the frequency of the participant’s payroll.  However, the plan may allow other methods of payment.  Each payment must include an allocation of principal and interest. The plan sponsor should carefully evaluate the payroll systems to ensure the amounts withheld for loan payments are properly determined and deposited to the plan timely.  A participant’s plan loan repayments are subject to the same deposit rules as the participant’s deferral contributions under the plan.  Plan loan repayments generally must be deposited  on the earliest date that it is reasonable for the employer to segregate the repayments from its general plan assets (with an exception for small employer plans that allows deposits made within 7 business days to be considered timely deposited).  Special caution should be used when there is a change in payroll systems or providers in order to ensure loan payments continue to be processed correctly.

Optional Loan Items to Consider

The 401(k) plan loan rules may (but are not required to) include the following provisions:

• A minimum loan amount may be set (typically, the minimum is $1,000).
• The number of plan loans permitted to be outstanding at one time may be limited (some plans only permit one outstanding loan at a time).
• The spouse of a married participant may be required to consent to the plan loan (some plans require this only for loans greater than $5,000).
• The plan may restrict the purposes for which a plan loan may be requested (if not specified, then the loan may be requested for any purpose).
• A “cure period” may be permitted in order to allow a participant to make up for a missed payment; however, the cure period cannot extend beyond the end of the quarter following the quarter in which the payment was due.

Plan Loan Errors May be Eligible for Correction Under EPCRS and VFCP

It is fairly common for operational errors to occur in setting up and administering plan loans.  If those errors are caught during the term of the loan, they may be eligible for correction under the Internal Revenue Service Employee Plans Compliance Resolution System (“EPCRS”). 

For any loan error which violates ERISA, the fiduciary issues can be addressed through the Department of Labor Voluntary Fiduciary Correction Program (VFCP) by filing proof of payment and a copy of the VCP compliance statement issued by the IRS with respect to the loan error correction.

Loans That Do Not Meet Legal Requirements and Cannot be Corrected

If a plan loan does not meet the 401(k) plan requirements and legal requirements when it is made (such as exceeding the maximum amount permitted), or if the plan is administered in a way that violates those requirements (such as not making loan payments in accordance with the schedule set out in the loan documents) and if the error cannot be corrected under EPCRS, the loan will be considered a “deemed distribution.” When the loan is considered a “deemed distribution,” the remaining balance is treated as a distribution that is subject to income tax and may be subject to the 10% early distribution tax.  The plan sponsor must issue a Form 1099-R to report the “deemed distribution.”