Participant Loan Basics

By David J. Kupstas, FSA, EA, MSPA

David J. Kupstas, FSA, EA, MSPA

David J. Kupstas, FSA, EA, MSPA Chief Actuary

Participant loans are a popular feature of 401(k)s and other qualified retirement plans. It is safe to say that if employees didn’t have the ability to borrow from their retirement account when times were tough, some number of these employees simply wouldn’t contribute to the plan in the first place.  This article goes over some of the rules related to participant loans. 

Loans Are Deemed Taxable Distributions until Proven Otherwise

The first thing the Internal Revenue Code says about participant loans is, if you take a loan, it’s treated as a taxable distribution from the plan. That’s pretty harsh. Fortunately, there are some exceptions that, if met, will allow the participant loan not to be deemed a distribution. These are the common rules about participant loans that are familiar to many. To avoid a deemed distribution, loans must be: 

  • Limited to the lesser of $50,000 or one-half of the participant’s account balance.
  • Repaid within five years, except for loans used to acquire a principal residence, which may have a longer term.
  • Paid back under a substantially level payment schedule no less frequently than quarterly.
  • Evidenced by a legally enforceable agreement which complies with the Code and regulations and includes the amount of loan, date of loan and repayment schedule.

The limitation on loan amounts is the combined amount of all loans the employee has outstanding. For example, an employee couldn’t take out one $50,000 loan, then another $50,000 loan, then another. All the loans combined have to be less than $50,000. Furthermore, when taking out a new loan, you have to look back at the highest balance of outstanding loans in the last year. If a loan balance is $30,000 now but was $35,000 a year ago, and the employee wants a second loan, the maximum new loan is $15,000, not $20,000. Of course, the participant’s total account balance (including outstanding loans) has to be greater than $100,000 to be able to have the maximum $50,000 in loans. Otherwise, he’s limited to half his account balance. The one-year highest outstanding balance lookback rule doesn’t apply for the one-half account balance limit, only the $50,000 limit. 

For home loans, a common repayment term is 10 years or 15 years. The loan has to be used for acquiring a principal residence. The loan can’t be for home renovations or a second home. 

There is also a requirement that loan interest rates be commercially reasonable. This should mean calling around to several local banks to find out what interest rates apply currently on similar loans. What happens in practice is that plans will often use some benchmark, such as the prime rate plus one or two percentage points. While this practice is very widespread, it is our understanding that the IRS has not endorsed it. 

When a Loan Is Deemed a Distribution 

As soon as one of the loan rules is violated, a deemed distribution occurs. This can be at the time the loan is made or at a later date: 

  • If the loan exceeds the limits, the portion of the loan that exceeds the limit is a deemed distribution.
  • If the loan documents are bad, meaning the term is too long or the payment schedule is not level or is less frequent than quarterly, there is a deemed distribution of the whole loan amount as soon as it is made.
  • If a scheduled payment is missed, there is a deemed distribution equal to the outstanding balance of the loan. 

For late payments, plans are allowed to have a grace period, which the regulations call a “cure period.” The cure period may not extend past the end of the calendar quarter following the calendar quarter in which the payment was missed. If the August 31 payment is missed, the cure period cannot extend beyond the following December 31. If the October 13 payment is missed, the cure period cannot extend beyond the following March 31. A plan does not have to allow a cure period at all. 

Most employees have their loans repaid via payroll deduction, so the risk of missing a payment should be small. The real risk comes if someone is repaying his loan by writing a check to the plan or if the payroll deduction doesn’t get set up properly. Theoretically, it is possible for an employee to ask for the payroll deduction to stop, but a plan sponsor either should not allow that or should think long and hard before doing so, because stopping a payroll deduction is a surefire way for an employee to default on a loan. 

Deemed Distribution vs. Actual Distribution 

Throughout this article, we have referred to “deemed distributions.” Taxwise, a deemed distribution is a lot like an actual distribution.  The deemed distribution amount gets reported on Form 1099-R. The employee must pay income taxes on the amount. If the employee is not yet age 59½, there is an additional 10% early withdrawal excise tax. 

Many plans do not allow actual distributions except under certain conditions such as termination, retirement, death or attainment of a certain age. If an actual distribution is made when the plan doesn’t allow it, the plan could be disqualified. Since a deemed distribution is not an actual distribution, there is no potential for plan disqualification if one occurs. 

Loans that have been deemed distributed are considered to remain outstanding and continue accruing interest. Tax is owed on the deemed distributed amount, but not on any additional interest that accrues (until that interest is withdrawn with the rest of the account balance). Deemed distributed loans remain on the books for determining whether future loans are within the limits or available at all. An employee may repay a loan that has been deemed distributed; if he does, he will have tax basis in the amounts repaid. The employee might want to do this to avail himself of loans in the future or simply to get the money back into an environment of tax-deferred growth. 

When a plan does not allow distributions to a particular employee, the employee might try to get cute and take out a loan with the intention of never paying it back. The regulations say that when there is “an express or tacit understanding that the loan will not be repaid,” then the loan is an actual distribution and not a deemed distribution, which could spell problems for the plan if the person receiving the actual distribution shouldn’t have been allowed to get one. 

When an employee terminates employment, many plans require loans to be repaid in full. If they are not repaid, then there is a loan offset amount, which is an actual distribution from the plan and not a deemed distribution. The new 2017 tax law allows more time  for rolling over offset amounts to an IRA than was allowed previously. 

Refinancing and Multiple Loans 

A plan may allow an employee to have more than one loan outstanding. Together, the loans may not exceed the dollar limits described above. 

Loans may be refinanced. Depending on how the refinancing is structured, the original loan and the refinanced loan may be considered one loan or they may be considered two separate loans outstanding at the same time. Below are a few examples. Assume the employee has a high enough account balance that $50,000 in loans may be outstanding: 

  • Tony borrows $50,000 to be repaid over five years. After two years, the outstanding balance of the loan is $32,000. Tony would like to restart the clock and repay the $32,000 over five years, which is considered a refinancing. This will not work.  Because the refinancing stretches the payment period past the maximum five years of the original loan, this is considered two separate $32,000 loans. The total outstanding balance would be $64,000, which is greater than $50,000 and so is too high. 
  • Assume instead that Tony repays his original loan for four years and has a $12,000 outstanding balance at that time. He wants to refinance the loan so the $12,000 is payable over five years (or after nine years from the original loan). This can be done. The highest balance in the last year was $23,000. When added to the refinanced amount of $12,000, the combined balance is only $35,000, which is less than $50,000. This really is no different than Tony taking out a new $12,000 loan and immediately paying back the original loan that has $12,000 left on it. You’re just cutting out the step of withdrawing $12,000 and paying it right back.
  • In the first example, assume Tony could get a better interest rate and so wanted to refinance the $32,000 to be payable over three years, but with a lower payment. Because he’s not going past the original five-year term of the original loan, the original loan and the refinanced loan are considered one $32,000 loan which falls within the limits, so this works. 

The regulations have other examples, including refinancings that increase the outstanding balance. When the loan is increased and the term extended, one way to satisfy the rules is to continue paying the amount owed on the original loan per the original schedule, then pay a lower amount beginning when the original loan term expires. 

Conditions on Loans 

The regulations say what a plan is allowed to do when it comes to participant loans. A plan can have more stringent loan rules than the law allows. A plan doesn’t even have to allow loans at all.  Just because it’s common for plans to have loans or because they’re allowed at your friend’s company doesn’t mean loans will be allowed in your plan. Administering loans can be a real headache that a small employer might not want to bother with. 

Instead of allowing any employee to get a loan for any reason, a plan may wish to restrict loans to hardship situations. Other restrictions may include a minimum loan amount, a limitation on the number of loans available, or a prohibition on refinancing. 

A plan document is often pretty sparse when it comes to rules on participant loans. Rather, plans should have a separate loan program detailing the plan’s rules on loans. The participants should be given this program to read prior to their taking a loan. The loan program is separate from the plan document so the whole plan won’t be disqualified if the loans are not administered correctly.

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— Topics: 401(k), participant loan