The Internal Revenue Service (“IRS”) has increased its level of scrutiny on the limitations imposed on participant loans from defined contribution retirement plans.
Internal Revenue Code (“IRC”) Section 72(p) generally limits a participant’s plan loans to the lesser of:
- $50,000, or
- 50% of the participants vested account balance.
Additionally, if the participant already took out a loan within the past 12 months or has an outstanding loan, the highest outstanding loan balance from the past 12 months must be subtracted from the dollar amount that the participant would otherwise be eligible to withdraw for a loan (i.e., subtracted from the lesser of $50,000 or 50% of the vested account balance). This means that even if the loans are fully repaid, the highest outstanding loan balance in the 12-month period still limits the amount the participant can borrow.
These rules are a mouthful. That is why the IRS has attempted to clarify how they work by providing an example in two recent memoranda from April and July, as well as a podcast in September:
Assume Bob, a plan participant, has a vested account balance in his employer’s 401(k) plan of $120,000. Bob borrowed $30,000 in February of 2017, and fully repaid this loan in April of 2017. Bob borrowed another $20,000 in May of 2017 and repaid this in full in July of 2017. Bob wishes to take out a third loan in December.
How does a plan administrator evaluate this third loan request? According to the memoranda, a plan administrator has two options to determine how to view the third loan request:
- The plan administrator could either determine that no further loan could be provided because $30,000 + $20,000 (the total of Bob’s first and second loans) = $50,000, which is the highest outstanding loan balance within a 12-month period; or
- The plan administrator could determine that the largest balance during the 12-month period is $30,000 and permit the third loan in the amount of $20,000.
The guidelines explain how the IRS would view the approval or denial of Bob’s third loan request during an audit. Using these guidelines, if a plan is audited by the IRS, the memoranda indicate that the agent would accept either the plan administrator’s denial of the third loan request or the allowance of the $20,000 loan if the plan administrator applied the rule consistently. Of course, the IRS adds the proviso that the memoranda are not a pronouncement of law and are not subject to use, citation, or reliance as a pronouncement of law.
In the podcast, the IRS indicated that it will be examining other loan requirements, including the requirements for level amortization and loan repayment over five years.
How can a plan administrator fix an error? If a plan administrator discovers that the maximum loan amount has been exceeded, the sponsor can correct this error using the IRS’ Voluntary Compliance Program (“VCP”). The correction is that the participant must repay the excess loan amount and, if needed, amortize the remaining principal balance as of the repayment date of the original loans’ remaining period. The corrective payment for the excess loan amount depends on the:
- excess amount as of the date of the loan;
- payments made on the loan; and
- portion of the previously made payments that were allocated to the excess loan amount.
If this is not corrected, it will be treated as a “deemed distribution.” A deemed distribution is treated as an actual distribution for purposes of determining the tax on the distribution, including any early distribution tax. A deemed distribution is not treated as an actual distribution for purposes of determining whether a plan satisfies the restrictions on in-service distributions applicable to certain plans. In addition, a deemed distribution is not eligible to be rolled over into an eligible retirement plan.
Loan payments can still be made even after a deemed distribution has occurred. In that case, the participant’s tax basis under the plan is increased by the amount of the late repayments.
About the Author: Eric W. Gregory is an associate in Dickinson Wright’s Troy office where he assists clients in the areas of ERISA, employee benefits, and compensation. He advises clients on all aspects of employee benefits including qualified retirement plans, welfare plans, and nonqualified compensation programs. Eric can be reached at 248-433-7669 or egregory@dickinsonwright.com and you can visit his bio here.
