When William Shakespeare wrote “neither a borrower nor a lender be,” he probably never envisioned a world in which millions of people could be both borrower and lender of their own retirement funds. Nor could he have anticipated that such loans would be available at extremely reasonable interest rates and without even an ounce of flesh as collateral! With all due respect to the great playwright, even the most profound and well-accepted adages need to be reevaluated in our rapidly changing society.

With the increased popularity of defined contribution plans, more plans are providing participants with the option of borrowing from their retirement accounts, especially 401(k) accounts, which are funded by their own salary deferrals.

There are a number of reasons why borrowing from a retirement account is a good idea. With interest rates at their lowest level in years, the cost of the loan is relatively inexpensive. In plans with individually invested accounts, the loan repayments are credited directly to the participant’s account. That means the account will own an investment with a guaranteed rate of return equal to the loan interest rate. With the recent uncertainty in the stock market and the extremely low rates being offered in fixed income investments, a loan with an interest rate above prime might be a welcome investment. Repayments are usually simplified through automatic salary reductions. Lastly, a plan loan may be easier to obtain than one at the local bank, since the accrued benefit may be the only collateral necessary.

In December of 2002, the IRS issued final loan regulations. What follows is an explanation of the final regulations along with the general requirements for retirement plan loans.

Prohibited Transaction Issues

Under ERISA and the Internal Revenue Code, transactions between a plan and a disqualified person are considered prohibited transactions. Disqualified persons include plan participants. There is an exemption for plan loans to participants if all of the following conditions are met:

• The plan must allow for loans and they must be available to all participants on a reasonably equivalent basis.
• The plan’s loan policy must not discriminate in favor of employees who are considered “highly compensated.”
• The loan must be adequately secured.
• The loan must bear a reasonable rate of interest.

If any of these requirements are not met, a plan loan will be considered a prohibited transaction subject to excise taxes and corrective procedures.

A plan that is subject to the survivor annuity requirements must also require spousal consent for loans to married participants that are secured by the participants’ accrued benefits, unless the accrued benefits are $5,000 or less. Without it, the loan will not be considered adequately secured.

The participant loan exemption previously did not apply to sole proprietors, partners owning more than 10% of a partnership and shareholders owning more than 5% of an S corporation. However, those restrictions were lifted by the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) in July 2001, effective for plan years beginning after December 31, 2001.

Loan Requirements and Limitations

In addition to the prohibited transaction rules, plan loans must meet the following requirements and limitations:

Dollar Limit

When calculating the dollar limit for a plan loan, all qualified plans of an employer, including employers who are related in a controlled group or an affiliated service group, are treated as one plan. A retirement plan loan, when added to the outstanding balance of all other loans under the plan, cannot exceed the lesser of $50,000 or 50% of the participant’s present value of vested benefits. The $50,000 ceiling is reduced by the amount that the highest outstanding loan balance during the previous year exceeds the current outstanding loan balance. In addition, if the plan permits, a loan for up to $10,000 can be made even if it exceeds 50% of the participant’s vested benefits, as long as it does not exceed 100% of such vested benefits. To the extent that it does exceed 50% under this provision, additional collateral is required, since no more than 50% of the participant’s vested benefits can be used as security for a loan.

Example

As of January 1, 2003, Derek had an outstanding loan under his employer’s 401(k) plan of $20,000, with total vested benefits of $100,000 ($80,000 in mutual funds, and $20,000 payable under the loan note). He wanted to take a second plan loan on that date. If Derek borrowed an additional $30,000, his new total loan balance would be $50,000, which equals the dollar limit and is exactly 50% of his vested benefits.

However, his highest outstanding balance during the previous 12 months was $28,000 (the January 1, 2002 balance). Since this amount exceeded the January 1, 2003 loan balance by $8,000, the $50,000 limit is reduced to $42,000. Consequently, Derek would be limited to a new loan of $22,000 ($42,000 – $20,000). Any amount above that level would be taxed as a “deemed distribution.”

Term of the Loan

Retirement plan loans must be repaid within five years, unless the loan is for the purchase of the participant’s principal residence, in which case it can be repaid over a longer period. The loan must be repaid pursuant to a level amortization schedule, which provides for both principal and interest payments no less frequently than quarterly.

Leave of Absence

A plan may allow a participant to cease loan repayments during a bona fide leave of absence of up to one year, either without pay or at a rate of pay (after taxes) that is less than the required loan payment. However, repayments must continue after the year is up, whether or not the leave of absence is over, and the loan must be fully repaid by the latest permissible term of the loan.

The participant can increase the amortized payments to make up for the missed payments, plus interest, or make a balloon payment at the end of the term. Loans originally established for less than the maximum permissible term can be extended up to the permissible term limit, but payments due after the allowable absence period cannot be less than the payments due under the original amortization schedule.

Military Leave

A plan may suspend required loan repayments during a period of military service, even if it lasts beyond one year. The final regulations state that interest will continue to accrue during the leave, but at a rate not in excess of 6%. Upon return, the loan payments must continue, but the final due date is extended by the length of the military leave of absence.

The participant can either increase the payments to pay off the interest that accrued during the military service, or pay it as a balloon payment at the end of the term. In addition, loans which were originally for a period of less than five years can be extended after military service so that the total term is up to five years plus the length of the military service. This is allowable even if it results in a reduction of payments from the original amortization schedule.

Example

Adrienne Do-Right volunteered for military service on April 1, 2001. At that time she had an outstanding loan from the XYZ Company 401(k) Plan that she had taken out on July 1, 2000, to be repaid by July 1, 2003 (three-year term). Adrienne expects to return to work for the XYZ Company on April 1, 2003, having missed two years.

She can resume the same loan payments until July 1, 2005, at which time she can make a balloon payment of two years worth of interest that accrued during her military leave (using the interest rate of the loan, not to exceed 6%). Alternatively, she can increase all of her remaining payments by the amount necessary to pay the additional accrued interest.

As a third option, she can revise the repayment schedule by extending the term of the loan two years (in addition to the extension for the leave) to July 1, 2007, since her original term was for three years instead of the allowable five years.

Loan Refinancing

If permitted by the plan, loan refinancing occurs when a participant replaces one loan with another. This might occur due to a change in interest rates or in the case of a participant who wants to increase the amount of his loan and the plan does not permit more than one loan.

Generally, the prior outstanding loan should continue to be repaid over a period no longer than the longest allowable term of the initial loan (generally five years unless a principal residence loan). Therefore, if the refinanced loan will be paid back within five years from the date of the original loan, the repayment requirements will be satisfied.

If any portion of the refinanced loan has a later repayment date than the original five-year period, the refinancing may result in a deemed distribution. An exception applies if a replacement loan contains two parts: one that refinances the original loan within its allowable term, and another that establishes a new loan to be amortized within the allowable term of the replacement loan.

Deemed Distributions

There are a number of circumstances which result in a loan being considered a deemed distribution. Loans that do not initially meet all of the statutory requirements will be taxed as deemed distributions. Once the loan has been issued, a deemed distribution will occur if a scheduled payment is missed. The loan is considered in default and the outstanding balance becomes the amount of the deemed distribution.

A plan may provide for a “cure” period during which the participant can make up the missed payment. Such cure period is acceptable if it does not extend beyond the calendar quarter following the quarter in which the missed payment occurred. A deemed distribution is taxable to the participant in the calendar year in which it occurs and is subject to a 10% penalty tax if the participant is under age 59½.

For purposes of determining the maximum amount of any subsequent plan loan, a deemed distribution that has not been repaid or offset (plus accrued interest) is still considered in effect and outstanding. If the loan is not repaid or offset, then subsequent loans will be taxable unless one of the following additional requirements are met:

• The participant enters into an enforceable agreement under which repayments will be made through payroll withholding, or
• The participant provides additional security for the new loan other than the accrued benefits under the plan.

Effective Date

The 2002 final loan regulations are effective for loans made from qualified plans after December 31, 2003. In the meantime, a reasonable, good faith compliance standard applies. The final regulations do not apply to loans made under certain insurance contracts that are in effect on December 31, 2003.

Conclusion

It is no surprise, given the current state of our economy, that participant loans from qualified plans are gaining in popularity. They provide a convenient way for employees to access their own funds in time of financial need, while also gaining a secure and competitive rate of return on their retirement investments. While there are still many rules that need to be followed, a properly administered loan program can be a valuable benefit to retirement plan participants.

This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.