401(k): Find and Fix – Participant Loans Weren’t Administered According to Plan Terms

An employee comes to you after taking out a loan against her 401(k).  She explains that it has been several months and no repayments are being taken out of her pay.  What needs to be done?  What should you do to ensure proper loan procedures are being followed?  How do you find and fix any other loan administration errors that may have already occurred?

Start by reviewing and following the loan rules outlined in the plan document and any loan policies or procedures established for the plan.  In addition, a participant loan must meet the following rules under the Internal Revenue Code and ERISA or the loan will be treated as a taxable distribution or a violation of ERISA:

1. The loan must be a legally enforceable agreement.
• It can be a paper or electronic document stating the date and amount of the loan and binding the participant to a repayment schedule.
• It must be a secured loan and the interest rate and repayment schedule should be similar to what a participant might expect to receive from a financial institution. Generally, the loan is secured by the participant’s account in the plan.
2. The amount of the loan can’t be more than 50% of the participant’s vested account balance up to a maximum of $50,000.
• There is an exception which allows loans up to $10,000, even if the loan amount exceeds 50% of the participant’s vested account balance. However, because a loan may not be secured by more than 50% of the vested account balance, additional collateral would be required to provide adequate security for the loan.  Because most 401(k) plans do not provide for security outside of the vested plan accounts, it is not common for a 401(k) plan to include this exception for loans up to $10,000.
• If the participant previously took out another loan, then the $50,000 limit is reduced by the highest outstanding loan balance during the one-year period ending on the day before the new loan. The practical effect of this rule is to limit a participant’s total principal amount of plan loans to $50,000 during any 12-month period.
3. The loan terms should require the participant to make level payments at least quarterly.
• Most plan loan payments are made through payroll withholding and based on the frequency of the participant’s payroll.
• Each payment should be the same amount and should include an allocation of principal and interest.
• The loan generally must be repaid within 5 years, unless the plan loan rules permit the participant to request a longer repayment period for a loan to purchase the participant’s main home.
4. Exceptions may be permitted for leaves of absence:
• The loan rules may permit the participant to suspend repayments for up to one year while the participant is on an approved:
• unpaid leave of absence, or
• paid leave of absence, if the participant’s rate of pay (after income and employment tax withholding) is less than the loan payment.
• Any suspension of payments may not result in a loan repayment period that exceeds the loan’s maximum repayment period (generally 5 years).
• On return from leave of absence, the participant must make additional payments to ensure repayment within the 5-year-period by either:
• increasing the payments over the rest of the loan, or
• keeping the payments the same, but making a catch up payment for the payments which were suspended during the leave of absence.

Click here for more information regarding plan loans.

How to find the mistake:

Review the outstanding loans, loan agreements, and loan repayments to:

~Determine whether there are written loan agreements for all outstanding loans.

~Review the terms of each loan agreement to ensure that the loan meets the following rules:

• The loan is due within 5 years (unless there is documentation in the file showing the loan was to purchase the participant’s main home).
• The interest rate is reasonable.
• The loan amount did not exceed the dollar limit (based on the participant’s vested account balance as of the loan date and whether the participant had any prior loans).
• The repayment schedule requires the participant to make level repayments at least quarterly, and the payments are properly calculated.

~Ensure that loan payments are timely made per the loan terms.

• A participant’s plan loan repayments are subject to the same deposit rules as the participant’s deferral contributions under the plan.
• Plan loan repayments generally must be deposited  on the earliest date that it is reasonable for the employer to segregate the repayments from its general plan assets (with an exception for small employer plans that allows deposits made within 7 business days to be considered timely deposited).

How to fix the mistake:

Corrective action:
It’s important that plans have a system in place to ensure that the terms of a participant loan and its repayments follow the law so the loan isn’t treated as a taxable distribution or a violation of ERISA.  Generally, once a loan violates a rule, it becomes a taxable distribution, unless the plan administrator can correct the violation:

~The plan administrator may allow for a “cure period” that would allow a participant to make up for a missed payment. The cure period can’t go beyond the end of the quarter following the quarter in which the missed payment was due.

~If the loan violated the plan document terms or the legal requirements for loans, the plan sponsor has two choices. It may be able:

• to use the Voluntary Correction Program (VCP) to permit employees to include the amount of the loan in income in the year of correction (as opposed to the year in which the problem occurred), or
• to use the VCP to request relief from reporting the loans as taxable distributions to participants, provided that:

-the employer’s action caused the violation of the loan rules, and

-correction is completed within the maximum time for the loan, usually 5 years.

~If the loan error violates ERISA, proof of payment and a copy of the VCP Compliance Statement must be filed with the DOL through the Voluntary Fiduciary Correction Program (VFCP).

The following describes the general requirements for correction of common plan loan errors through VCP:

Loan that exceeds the dollar limit: The participant must repay the excess loan amount and, if needed, amortize the remaining principal balance as of the repayment date over the original loan’s remaining period. The corrective payment for the excess loan amount depends on the:

• excess amount as of the date of the loan,
• payments previously made on the loan, and
• portion of the previously made payments that were allocated to the excess loan amount.

Three alternative methods that may be used to determine the allocation of prior repayments toward the excess loan amount and the corrective payment required to repay the excess loan amount are:

1. Prior repayments are applied to reduce the portion of the loan that didn’t exceed the limit. None of the prior payments are allocated to the excess loan amount. The corrective payment for the excess loan amount is equal to the original loan excess, plus interest.
2. Prior repayments are used to pay the interest on the excess portion of the loan, with the remainder of the repayments used to reduce the portion of the loan that didn’t exceed the limit. The corrective payment for the excess loan amount is equal to the original excess loan amount.
3. Prior repayments are applied against the loan excess and the permissible maximum loan amount on a pro-rata basis. The corrective payment for the excess loan amount is equal to the outstanding loan balance attributable to the excess loan amount, after the allocation of prior repayments.

Loan that exceeds the maximum loan period: The outstanding amount of the loan is reamortized over the maximum remaining period allowed by law (generally 5 years, unless a longer term is provided under the plan for a loan to purchase the participant’s main home) from the original loan date.

Loan that’s in default (after the passage of the “cure period”) because of the failure to make timely payments: The participant must either:

• make a lump sum payment for the missed installments (adjusted for interest);
• reamortize the outstanding loan balance, resulting in higher payments going forward; or
• a combination of a make-up payment and reamortization of the loan.

Corrective action (through examples):
AZCorp 401(k) Plan maintains a participant loan program. The plan has 50 participants, three of whom had participant loans.  At the end of 2012, AZCorp conducted a year-end review of its loan program and found the issues below.  The errors were corrected on February 1, 2013, and AZCorp filed a VCP application with the IRS and a VFCP application with the DOL.

Bob – Loan amount in excess of the $50,000 limit – Bob received a plan loan on May 1, 2012. The loan was for $60,000 over a 5-year term, amortized monthly using a reasonable interest rate. Bob timely made the required payments. The loan amount is less than 50% of Bob’s vested account balance. However, the loan amount exceeds the maximum limit of $50,000.

Bob’s Correction – AZCorp corrected this mistake by requiring a corrective repayment to the plan because of the $10,000 loan excess, according to Method 3, above. Since Bob has already repaid some of the loan, these repaid amounts may be considered in determining the amount of the required corrective repayment. AZCorp applied Bob’s prior repayments on a pro-rata basis between the $10,000 loan excess and the $50,000 maximum loan amount. Therefore, Bob’s corrective repayment equaled the balance remaining on the $10,000 loan excess as of February 1, 2013, the date of correction.

Terri – Loan term in excess of the 5-year limit – Terri received a loan of $10,000, dated April 1, 2012, to be paid back over a six-year period. Payments are timely and the interest rate is reasonable. The loan term exceeds the maximum 5-year repayment period.

Terri’s Correction – AZCorp is correcting this mistake by reamortizing the loan balance over the maximum remaining period (5 years) from the original loan date. On February 1, 2013, AZCorp reamortized the loan balance for Terri so that it will be fully repaid by April 1, 2017 (5 years from the date of the original loan).

Dean – Loan payments not made – Dean borrowed $10,000, dated March 1, 2012, over a 5-year period. Because of a payroll error, AZCorp failed to withhold the required loan repayments from Dean’s pay since August 1, 2012. The loan amount is less than 50% of Dean’s vested account balance and the interest rate is reasonable.

Dean’s Correction – The loan went into default as of December 31, 2012, on the expiration of the plan’s stated cure period. AZCorp determined it was at fault because it failed to collect loan repayments. AZCorp corrected the mistake by requiring Dean to make a lump sum repayment equal to the additional interest accrued on the loan and by reamortizing the outstanding balance over the payroll periods remaining in the 5-year loan period.

Correction programs available:

Click here for a detailed description of the following qualified plan correction programs available under the IRS Employee Plans Compliance Resolution System (EPCRS):

Self-Correction Program (SCP):
The types of plan loan errors described above can’t be corrected under SCP. AZCorp must correct under VCP.

Voluntary Correction Program (VCP):
AZCorp may file a VCP submission to correct the loan errors described above. The fee for the VCP submission is generally based on the number of plan participants. However, EPCRS provides for a 50% fee reduction when the loan failure is the only failure of the submission and no more than one quarter of the participants are affected by participant loan errors. For the corrective actions described above, because no more than one quarter of AZCorp’s 50 employees were affected by the mistake, the VCP fee is $500 ($1,000 x 50%).

Audit Closing Agreement Program (Audit CAP):
If the loan errors described above were discovered by the IRS during audit, the corrective actions under Audit CAP would still be the same.  However, Employer AZCorp and the IRS would enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.

Click here for information regarding the Department of Labor (DOL) Voluntary Fiduciary Correction Program (VFCP) which can be used to address the fiduciary issues related to any loan error that violates ERISA.  To complete a VFCP application, the plan sponsor must provide proof of payment and a copy of the VCP compliance statement issued by the IRS regarding the loan error correction.

How to avoid the mistake:

Develop loan procedures and forms, including:

• A system for determining the participant’s maximum loan amount (based on participant’s account balance and prior loan history), term, and repayment amounts.
• A written policy used to determine the loan terms (such as the interest rate).
• Written, enforceable loan agreements.
• A “cure” period (see “How to fix the mistake”) which allows the plan administrator a window of time to get a payment from the participant without it being considered a missed payment.
• Any documentation requirement for requesting a loan (for example, proof that a loan is being used to purchase the participant’s main home, if the plan approves loans for over 5 years).
• A system for monitoring timely repayment, including coordination with the payroll system for payments made by payroll deduction.
• A system for analyzing deposits and allocations of loan payments.

401(k) Plan Fix-It Guide
401(k) Plan Overview
EPCRS Overview
401(k) Plan Fix-It Guide (pdf)
401(k) Plan Checklist
Additional Resources