environment of the last few years created financial challenges for
individuals and businesses alike. Even though the worst of the
recession appears to be behind us now, some of those financial
challenges have had a ripple effect that continues to show itself.
One area where that is especially true relates to the loans
participants took from their 401(k) plans. Economic pressures
certainly brought about an increase in loans, but it also caused
some participants with loans to have trouble repaying them.
A quick review of the rules that govern qualified plan loans may
help to provide some context. The Employee Retirement Income
Security Act (ERISA) prohibits plans from loaning money to related
parties, including participants, unless certain requirements are
satisfied. The Tax Code also has its own rules that parallel and
supplement those found in ERISA. In other words, loans start bad and
must be made good.
Here is a quick overview of some of the key requirements for
making a bad loan good.
- Amount: The maximum loan a
participant can take is 50% of his or her vested account balance
up to $50,000 (reduced by the highest outstanding loan balance
in the immediately preceding 12-month period).
- Duration: A participant
loan cannot be amortized for more than five years. There is an
exception, however. If the participant will use the loan to
purchase his or her primary residence, the plan can allow the
loan to be amortized for longer than five years.
- Payments: Loans must have a
level amortization with payments of principal and interest made
at least quarterly.
- Interest: Loans must use an
interest rate that is reasonable in light of what a commercial
lender would charge for a similar loan.
- Enforcement: A participant
loan must be an enforceable agreement under state law. This
translates into a requirement that the loan be in writing.
- Documentation: The plan
document must specifically authorize participant loans. It must
also include (either within the document or through a separate
written policy) the above parameters and require that all loans
remain within those parameters.
The above rules are "bookends" of sorts. A company may choose to
further limit its loan provisions but it cannot go outside of the
bookends. For example, many plans limit a participant to only one
loan at a time or establish a minimum loan amount of $1,000. Another
common provision is to require loans to be amortized according to
the company's payroll schedule and payments to be through payroll
deduction. A plan that chooses to impose restrictions must follow
those limitations even if the bookends would allow more liberal
In order for a bad loan to go good, it must satisfy all of these
Going to the Dark Side
Just as bad loans can be made good, good loans can go bad if, at
any time during their duration, they fail to satisfy any one of the
rules…no matter how insignificant or well-intentioned the oversight
might seem. This can lead to taxes, penalties and administrative
burdens for both the plan and the participant.
Before delving into some of the ways loans can go bad, let's
define a few terms.
When a participant misses a regularly scheduled loan payment, the
loan goes into default. This is almost like loan purgatory; some
sort of correction is required but the loan has not yet reached the
point of no return.
The loan regulations provide for a "cure period" for making up a
missed loan payment. It extends through the end of the calendar
quarter following the quarter in which the default occurs. In other
words, once a participant misses one or more payments, he or she has
until the end of the following quarter to make up the shortfall
along with accrued interest to cure the default and prevent a deemed
This is when some or all of the outstanding balance of a loan is
treated as a taxable distribution to the participant. This can occur
either when a defaulted loan is not cured by the end of the cure
period or when a loan is otherwise defective in some way.
There are two aspects of deemed distributions that are often
- There is no action required to trigger the tax liability.
Just like a person's paycheck is subject to income tax
regardless of whether they get a W-2 at the end of the year, a
deemed distributed loan is taxable even if no one takes steps to
report it on a Form 1099-R. If the participant does not report
the amount in question on his or her income tax return, it could
generate additional penalties and interest for underpayment of
- A deemed distribution does not extinguish the participant's
obligation to repay the loan. In other words, a deemed
distributed loan is taxable (and may include a 10% early
withdrawal penalty), but the participant must still repay it. To
make matters worse, those post-deemed-distribution loan payments
create tax basis in the plan and must be tracked as a separate
money source on the recordkeeping system.
A deemed distributed loan continues to be included as a plan
asset until the participant in question has a distributable event,
usually termination of employment. At that time, the outstanding
balance is offset and reported on the plan's financial statements as
an actual distribution.
Examples of Good Loans Gone Bad
Now that we have reviewed the rules and defined some key terms,
it is time to review some of the more common situations that can
cause a good loan to go bad.
Loans Not Permitted
Plans are not required to offer loans but those that wish to
allow loans must be sure the appropriate provisions are included in
the plan document and/or separate written loan policy. Plan sponsors
may believe they are helping a participant in need of cash by
approving a loan request without going to the formality of amending
the plan document; however, issuing a loan when the plan does not
allow it results in a loan that never becomes good. The full amount
of the loan is immediately deemed distributed.
Generally, a plan can offer loans at any point during the year as
long as an amendment is adopted by the end of that year to add the
necessary language to the plan document. However, once the year
closes, there are fewer options for correction.
Refinancing Not Permitted
When homeowners wish to change their mortgage to get a lower
interest rate or borrow additional money, they do so by refinancing
their mortgage. Participant loans operate the same way. In order to
change the terms of a loan, the participant must refinance it. The
trick is that not all plans permit refinancing. Furthermore,
inability to refinance is not always crystal clear. Consider a plan
that permits loans but restricts participants to only one loan at a
time. IRS regulations (and the U.S. Tax Court) look at certain
refinancing transactions as consisting of two loans--the replacement
loan (the new one) and the replaced loan (the old one). Therefore,
the refinance transaction violates the one loan at a time limit, and
the replacement loan is a deemed distribution. This can be addressed
by amending the loan provisions to specifically permit refinancing
or to allow multiple loans.
Loan Term Too Long
If a loan is amortized for longer than permitted, it is defective
from the moment it is issued and the entire amount is a deemed
distribution. A common example of this is when a plan issues a
general purpose loan for longer than five years. Since that is a
regulatory limit, this type of defect cannot be remedied by amending
the plan to allow a longer amortization.
On the other hand, if a particular plan elects to limit all loans
to only five years but issues a residential loan with a longer
amortization period, it may be possible to amend the plan within the
time frame described above.
Payments Never Started
Sometimes a participant takes a loan that is to be repaid by
payroll deduction, but the payroll system does not get set up to
begin withholding payments. Although there is some latitude,
payments should begin within one or two pay periods following
issuance of the loan. If that does not occur, the loan goes into
default. Unlike the previous examples, this does not cause the
entire loan to be defective. Rather, the participant has until the
end of the cure period to get principal and accrued interest
payments up to date and avoid a deemed distribution.
Payments Voluntarily Suspended or
In other circumstances, a participant with a loan determines that
he or she can no longer afford to make payments and asks the company
to stop withholding on a temporary or permanent basis. Some
employers may be inclined to help an employee in that situation by
agreeing to the request. Unfortunately, doing so causes the loan to
default (and maybe become a deemed distribution), and it also
subjects plan fiduciaries to liability for breaching their
Even though the participant is borrowing from his or her own
account balance, the loan is still considered an asset of the plan.
By voluntarily discontinuing the withholding of payments, the plan
sponsor fails to enforce a legal agreement between the plan and the
participant and allows a plan asset to decrease in value.
Coming Back to the Light
Fortunately, many loans that have crossed over can be brought
back to the light. The IRS Employee Plans Compliance Resolution
System (EPCRS) includes a series of voluntary correction mechanisms,
including several for participant loans. Generally, defective loans
are corrected by reforming them so that they comply with the
applicable rules. Depending on the circumstances, other correction
options may also be available. This could include retroactively
amending a plan (effective in a previous year) to permit a loan that
was issued in error.
Unlike other types of oversights, EPCRS does not permit
self-correction. In other words, bringing a bad loan back from the
dark side requires submitting documentation of the correction to the
IRS for their approval.
As you can see, the participant loan rules can be challenging
even in good economic times. With all of the potential missteps that
can occur, it is important to work with knowledgeable service
providers that have strong checks and balances designed to properly
administer participant loans. By also implementing similar controls
internally, plan sponsors can make sure that good loans don't go
This newsletter is intended to provide general information on
matters of interest in the area of qualified retirement plans and is
distributed with the understanding that the publisher and
distributor are not rendering legal, tax or other professional
advice. Readers should not act or rely on any information in this
newsletter without first seeking the advice of an independent tax
advisor such as an attorney or CPA.