A Plan Sponsor's Introduction to Retirement Plan Loans

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Hi, I'm Mikio, and I work for the Internal Revenue Service.

Loans through your business' retirement plan can help your employees through challenging economic times. However, it's important to know the rules before this lifeline results in unexpected tax consequences.

As an employer, you're not obligated to draft your retirement plan to allow loans. And not all types of plans can offer loans. For example, IRAs, SEP IRAs and SIMPLE IRAs can't offer loans, but 401(k), profit-sharing and 403(b) plans can.

If you want to allow loans from your plan, your plan document or written loan program must specify the loan rules, such as limits on loan amounts, procedures for obtaining loans, and loan repayment terms. 

It should also explain loan defaults – when they occur and their consequences – such as using an employee's account balance to repay the loan.

Retirement plan loans must be available to all your plan participants - rank and file employees, highly compensated employees, officers or shareholders - on a reasonably equivalent basis. 

When approving a loan, you should only consider the factors that a commercial lender would consider, such as the applicant's creditworthiness. 

The tax law limits the amount a participant can borrow to 50% of the participant's vested account balance or $50,000, whichever is less.  If one-half of the vested account balance is less than $10,000, the employee can borrow up to $10,000, but a plan isn't required to include this exception, and most don't. The $50,000 limit must be reduced by the highest outstanding loan balance the employee had at any time during the year before the loan. This means that your employee can't repay a $50,000 loan one day and take out another $50,000 loan a week later.

Let's look at a couple of examples.

Bill's vested account balance is $80,000. Bill may take a loan up to $40,000, which is 50% of his vested account balance.

If Bill's vested account balance is $120,000, he can only take a loan up to $50,000, even though this is less than 50% of his vested account balance.

The loan repayment terms must require the employee to repay the loan in substantially equal payments, at least quarterly, over no more than five years. There's an exception to the 5-year requirement if the employee is using the loan to purchase a principal residence.

Loans that don't meet these requirements are considered "deemed distributions" and must be reported on Form 1099-R.  For instance, if the loan repayments aren't made at least quarterly, the remaining balance is treated as a distribution subject to income tax and an additional 10-percent tax if the employee is under age 59½. If the employee incurs a deemed distribution with respect to a loan, in order to disregard this loan when determining the maximum amount of any future loan – to wipe the slate clean, so to speak - he or she must make the loan payments in full. These amounts are treated as basis and won't be taxable when later distributed from the plan.

What happens if your employee leaves your company before he repays the loan? You may require the employee to completely repay the loan. If he is unable to do so, then you'll reduce his or her plan account by the balance on the loan and treat it as an actual distribution, reported on Form 1099-R.

The employee can avoid the immediate income tax consequences if he is able to make up the amount of the loan's outstanding balance from other sources within 60 days and roll over this amount to an IRA or eligible retirement plan.

If your employee is in the armed forces, you may suspend the loan repayments during the employee's period of active duty and then extend the loan repayment period by this same amount of time.

If during a leave of absence, an employee's salary is reduced and considered insufficient to repay the loan, you may suspend repayment for up to a year. Unlike the exception for active members of the armed forces, the loan repayment period isn't extended and the employee may need to increase the scheduled payment amounts to pay off the loan in the originally scheduled period.

Some plans require a participant's spouse to consent to the loan in writing before making a loan. A few plans may require consent only for loans totaling more than $5,000. Most profit-sharing and 401(k) plans do not require spousal consent for a loan, regardless of the amount.

Spousal consent is only valid if it's in writing and witnessed by a notary public or the plan administrator and is made no earlier than the beginning of the 90-day period ending on the date that the loan is secured by the accrued benefit.

So what happens if you run into a problem with one of the loans from your retirement plan, such as an employee who doesn't meet the repayment schedule because you forgot to deduct the amounts from the employee's salary or if you mistakenly allowed a loan that was more than the limit stated in the plan?

A plan loan failure can be corrected through the IRS Voluntary Correction Program. If a defaulted loan is still within the 5-year repayment period, you may be able to reamortize the loan without having to report the loan as a distribution on Form 1099-R. The loan should be reamortized so that it's repaid before the fifth anniversary of the date the money was first paid out of the plan. Remember to count the five years from the date your employee received the money and not from the first repayment date.

Alternatively, if too much time has passed for the loan to be re-amortized, you can request to issue the Form 1099-R reporting the deemed distribution in the year of the correction instead of the year the loan went into default.

Should employees borrow from their retirement plan?

Before an employee decides to take a loan from their retirement account, they should consult a financial planner who will help them decide if this is the best option for them or if it would be better to obtain a loan from a financial institution or other source.