What Are the Biggest Problems With 401(k) Loans?

Most workplace retirement plans allow participants to take a loan against their retirement plan balance – but administering the option carries risks for plan fiduciaries. Here are what the IRS has identified as the most common plan loan failures.

A plan loan is a taxable distribution unless the loan satisfies the exception under Internal Revenue Code Section 72(p)(2) which sets limits on the amount of a nontaxable loan and the repayment of the loan. Participants may receive a nontaxable loan of up to 50% of their vested account balance not to exceed $50,000 (a minimum loan up to $10,000 can be made that exceeds the 50% rule as long as the excess is secured with additional collateral). The participant loan, by its terms, must be repaid within 5 years (unless it is for the purchase of a primary residence), and principal and interest must be paid in substantially level payments at least quarterly.

With those conditions in mind, the IRS says that the most common plan failures regarding loans are:

  • loans that exceed the maximum dollar amount;
  • loans with payment schedules that don’t comply with the time or payment limits; and
  • defaulted loans due to failure to make required payments.

Any of these will cause the loan (or portion thereof) to become a “deemed” distribution for tax purposes. In those cases, the participant is taxed as if the distribution were received, but the treatment of the loan as a distribution does not excuse the participant from the obligation to repay the loan. From the standpoint of the plan fiduciary, a failure to repay the loan may result in additional tax consequences and, in some cases, a prohibited transaction.

If the plan contains language that reflects the loan limits under Section 72(p)(2), the violations discussed will also cause a plan to become disqualified, resulting in adverse tax consequences to the employer and employees under the plan; however, employers may get relief from these adverse consequences through the Employee Plans Compliance Resolution System (EPCRS) by correcting the failures. The Voluntary Correction Program (VCP) can be used to correct these mistakes.

More information from the IRS on these issues – and how your plan sponsor clients can correct them – is available online here.

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