Case of the Week: Reasonable Interest Rate on Plan Loan

The ERISA consultants at the Retirement Learning Center Resource regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and executive compensation arrangements.

A recent call with a financial advisor from Ohio is representative of a common inquiry related to 401(k) plan loans. The advisor asked:

“What interest rate should a plan apply as part of its plan loan program?”

Highlights of Discussion

Loans to 401(k) plan participants are generally prohibited unless they:

  • are available to all plan participants and beneficiaries on a reasonably equivalent basis;
  • are not made more readily available to highly compensated employees, officers or shareholders than they are to other employees;
  • are made in accordance with specific provisions set forth in the plan;
  • are adequately secured; and
  • bear a reasonable rate of interest [see DOL Reg. § 2550.408b-1].

The Department of Labor (DOL) gives us a guideline for what is reasonable, but with room for interpretation. According to DOL Reg. § 2550.408b-1(e), a plan’s loan interest rate is reasonable if it is equal to commercial lending interest rates under similar circumstances (see also DOL Advisory Opinion 81-12A). In an example, the DOL explains: “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.”

The IRS has similar requirements in order for a plan loan to avoid excise tax under Internal Revenue Code § 4795(c) and (d)(1) for prohibited transactions. In a Sept. 12, 2011 IRS phone forum, IRS personnel stated informally: “…as a general rule the Service generally considers prime plus 2% as a reasonable interest rate for participant loans.” The prime rate is an interest rate determined by individual banks. It is often used as a reference rate (also called the base rate) for many types of loans.1 Conceivably, adding one or two percentage points to the prime rate makes the interest rate charged to a participant more consistent with general consumer rates, as individuals can rarely get a loan at the going prime rate.

In its Winter 2012 publication, “Retirement News for Employers,” the IRS suggests asking the following questions to determine if a loan interest rate meets the reasonable standard:

  • 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?

According to Internal Revenue Manuals, Part 4, Section 4.72.11.4.2.1.1, IRS examination steps related to verifying a reasonable rate of interest include:

  • determining whether the plan loans’ interest rates and other conditions are comparable to the terms of similar commercial loans in the relevant community; and
  • checking the overall rate of return on plan assets when a large percent of the plan’s assets are invested in participant loans.

On the second point above, even if the interest rate on the loans is reasonable, the overall rate of return might be unreasonable. This could occur if it is determined that the substantial investment in participant loans is causing the overall rate of return to be materially less than what could have been earned in other investment options under the plan. The DOL has provided that a participant loan as an investment would not be prudent if it provided the plan with less return, relative to risk, than comparable investments available to the plan.

Plan sponsors must: (1) take into consideration relevant current market conditions; and (2) conduct periodic reviews of the interest rate to ensure it continues to reflect current market conditions. Any time a participant loan is refinanced, the interest rate should be updated.

Above all, plan sponsors must be able to document the process they used to determine a reasonable interest rates for participant loans in order justify their selection.

Conclusion

Determining reasonableness is a question of fact and there is no “safe harbor” rate.

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“Case of the Week” is the winner of an APEX Award for Publication Excellence for 2017.

Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Consumers should consult with their tax advisor or attorney regarding their specific situation.

©2018, Retirement Learning Center, LLC. Used with permission.

Footnote

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