The ERISA consultants at the Columbia Management Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with a financial advisor in Indiana is representative of a common inquiry involving plan loans. The advisor asked:
“My client has a 401(k) plan that offers loans to participants. What interest rate should he apply to the loans?”
Highlights of Recommendations
• A plan loan to a participant is an investment of plan assets, and must bear a “reasonable rate of interest.”
• Department of Labor regulations explain that a reasonable rate of interest is one that is equal to commercial lending interest rates that apply under similar circumstances (DOL Reg. §2550.408b-1(e)). These regulations provide several examples, including the following:
"EXAMPLE: Plan P makes a participant loan to A at the fixed interest rate of 8% for 5 years. 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 A's creditworthiness and the collateral offered. One bank would charge a variable rate of 10% adjusted monthly for a similar loan. The other bank would charge a fixed rate of 12% under similar circumstances. Under these facts, the loan to A would not bear a reasonable rate of interest because the loan did not provide P with a return commensurate with interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances. As a result, the loan would fail to meet the requirements of ERISA §408(b)(1)(D) and would not be covered by the relief provided by ERISA §408(b)(1)."
• To determine if a participant loan interest rate is reasonable, the IRS, in its Winter 2012 Retirement News for Employers electronic newsletter suggests plan sponsors ask these questions:
— What current rates are local banks charging for similar loans (amount and duration) to individuals with similar creditworthiness and collateral?
— Is the plan rate consistent with the local rates?
• Additionally, in a 2011 IRS phone forum on plan loans, IRS representatives indicated that the IRS generally considers the prime interest rate plus two percentage points as a reasonable interest rate for participant loans.
• Your client should also check the loan documents used by the plan for language that references the applicable interest rate.
• Unless a plan assesses a reasonable rate of interest on participant loans, the loans may result in prohibited transactions under DOL Reg. §2550.408b-1(a) and Internal Revenue Code §4975(c)(1)(B)).
Conclusion
There are many requirements that a participant loan from a qualified retirement plan must meet in order to avoid running afoul of the IRS’ and DOL’s prohibited transaction rules. One key element is the use of a reasonable interest rate. Financial advisors who are familiar with what the IRS and DOL may consider as a reasonable interest rate are better positioned to support their plan sponsor clients.
The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2013 Columbia Management Investment Advisers, LLC. Used with permission.
