Bill Green, BridgeTower Media Newswires
To some employees, a loan from their retirement plan account seems like a convenient and quick way to access some much-needed cash. However, these transactions can carry pitfalls with them that both participants and plan sponsors need to be wary of.
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Background
Many plan sponsors of profit-sharing, money purchase, 401(k), 403(b) and 457(b) retirement plans allow participants to borrow from their retirement account. Maximum borrowings are generally limited to the lesser of 50% of the participant’s vested account balance or $50,000.
Unless the loan is used to purchase a primary residence, the participant must repay the loan within five years and make level repayments at least quarterly according to an amortization schedule.
As long as the applicable regulations are followed throughout the loan term, the transaction is not subject to tax or an early-withdrawal penalty (if under age 59 ½) as would be the case with most outright distributions from a retirement plan, including hardship withdrawals. From the plan sponsors’ perspective, compliance with these regulations is necessary to maintain the favored or “qualified” tax status of the plan.
What are the retirement plan loan pitfalls and what, if anything, can be done to address them?
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Loans that exceed the maximum dollar amount
If a participant loan is in excess of the maximum amount allowed, the excess portion, if uncorrected, becomes a “deemed” distribution for tax purposes. Under the deemed distribution rules, the participant would be taxed on the excess portion, potentially with early-withdrawal penalties, as if a distribution was received. In addition, the participant would still be obligated to repay the full amount of the loan. The repayment of the excess amounts would be treated as an increase in tax basis when cash distributions are made at a subsequent date, such as retirement.
The plan sponsor may use the Voluntary Correction Program (VCP), which is one of the three correction programs under the Employee Plans Compliance Resolution System, to apply to correct a loan that exceeds the allowable maximum dollar amount. When a failure to comply with this regulation occurs, a correction under VCP will generally be permitted if there is a payment to the plan based on the excess loan amount with certain adjustments if loan repayments commenced before the correction.
One important item to note when using the VCP is that the program can only be used to make a correction when the statutory term of a loan has not expired. Once the statutory term of a loan has expired, the VCP can only be used to report a deemed distribution.
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Loans that do not meet the repayment term limits
Except when the loan is made for the purchase of a primary residence, the entire balance of a participant loan that has more than a five-year repayment term, unless corrected, is deemed a distribution.
When a failure to comply with this regulation occurs, a correction under VCP will generally be permitted if the loan is re-amortized over the allowable remaining period of time considering a maximum repayment period at the date the loan was originated. For example, in order to correct a six-year term loan after the loan was in effect for one year, the loan would have to be re-amortized and the payment amount adjusted over the remaining four years of the maximum allowable term of five years.
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Loans in default due to nonpayment
If a loan goes into default due to a failure to make required payments, the outstanding balance is deemed a distribution. A plan may provide under the regulations a cure period that allows the participant to settle missed payments by the end of the calendar quarter following the quarter in which required payment(s) were due.
During a cure period, the missed payments can be corrected if the participant:
• Makes a lump sum payment equal to the amount that should have been paid to the plan, along with interest;
• Re-amortizes the entire unpaid portion of the loan over the allowable remaining period of time on the original loan; or
• A combination of 1 and 2.
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Loans to a participant that leaves the organization
This situation can be particularly overwhelming, but fortunately the tax overhaul has eased the repayment requirements. In the past, an outstanding loan, regardless of the remaining loan term, became due in full within 60 days of termination of employment. This meant the participant usually had 60 days to either 1) repay the loan in full, 2) roll their account balance, including the outstanding loan, into their new employer’s plan if the new plan accepts loan rollovers, or 3) allow the loan to become a deemed distribution.
However, beginning with loans treated as distributions after Dec. 31, 2017, the repayment period as a result of changing jobs has been extended to the due date of the participant’s federal income tax return, including extensions. As a result, participants with outstanding loans could now have until Oct. 15 of the year after they change jobs to repay or rollover the loan before it would become a deemed distribution.
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Loan fees
There typically are fees associated with retirement plan loans. Origination and annual administrative maintenance fees are normally flat dollar charges that add a couple of hundreds of dollars in expense to the loan over its term. This can result in the loan being costlier than higher interest rate alternatives that don’t assess additional fees.
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Lost opportunity
While a retirement plan loan may appear to some participants as a cost-effective borrowing option, it is important to also consider the potential lost investment return on the loan proceeds. While the loan proceeds remain outside of the participant’s account the participant is missing out on investment returns on the borrowed money. In a period of economic growth, the missed opportunity during a five-year loan could exceed 50% of the amount borrowed.
Retirement plan loans are quite popular today, as an estimated 15% to 20% of eligible participants have a loan against their account. Despite their popularity, employees should proceed with caution when borrowing against their retirement account.
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Bill Green, CPA, is a senior manager at Mengel, Metzger, Barr & Co. LLP. He may be reached at wgreen@mmb-co.com.
