The economic environment of the last few years created financial challenges for individuals and businesses alike. Even though the worst of the recession appears to be behind us now, some of those financial challenges have had a ripple effect that continues to show itself. One area where that is especially true relates to the loans participants took from their 401(k) plans. Economic pressures certainly brought about an increase in loans, but it also caused some participants with loans to have trouble repaying them.
Background
A quick review of the rules that govern qualified plan loans may help to provide some context. The Employee Retirement Income Security Act (ERISA) prohibits plans from loaning money to related parties, including participants, unless certain requirements are satisfied. The Tax Code also has its own rules that parallel and supplement those found in ERISA. In other words, loans start bad and must be made good.
Here is a quick overview of some of the key requirements for making a bad loan good.
- Amount: The maximum loan a participant can take is 50% of his or her vested account balance up to $50,000 (reduced by the highest outstanding loan balance in the immediately preceding 12-month period).
- Duration: A participant loan cannot be amortized for more than five years. There is an exception, however. If the participant will use the loan to purchase his or her primary residence, the plan can allow the loan to be amortized for longer than five years.
- Payments: Loans must have a level amortization with payments of principal and interest made at least quarterly.
- Interest: Loans must use an interest rate that is reasonable in light of what a commercial lender would charge for a similar loan.
- Enforcement: A participant loan must be an enforceable agreement under state law. This translates into a requirement that the loan be in writing.
- Documentation: The plan document must specifically authorize participant loans. It must also include (either within the document or through a separate written policy) the above parameters and require that all loans remain within those parameters.
The above rules are “bookends” of sorts. A company may choose to further limit its loan provisions but it cannot go outside of the bookends. For example, many plans limit a participant to only one loan at a time or establish a minimum loan amount of $1,000. Another common provision is to require loans to be amortized according to the company’s payroll schedule and payments to be through payroll deduction. A plan that chooses to impose restrictions must follow those limitations even if the bookends would allow more liberal treatment.
In order for a bad loan to go good, it must satisfy all of these rules.
Going to the Dark Side
Just as bad loans can be made good, good loans can go bad if, at any time during their duration, they fail to satisfy any one of the rules…no matter how insignificant or well-intentioned the oversight might seem. This can lead to taxes, penalties and administrative burdens for both the plan and the participant.
Before delving into some of the ways loans can go bad, let’s define a few terms.
Default
When a participant misses a regularly scheduled loan payment, the loan goes into default. This is almost like loan purgatory; some sort of correction is required but the loan has not yet reached the point of no return.
Cure Period
The loan regulations provide for a “cure period” for making up a missed loan payment. It extends through the end of the calendar quarter following the quarter in which the default occurs. In other words, once a participant misses one or more payments, he or she has until the end of the following quarter to make up the shortfall along with accrued interest to cure the default and prevent a deemed distribution.
Deemed Distribution
This is when some or all of the outstanding balance of a loan is treated as a taxable distribution to the participant. This can occur either when a defaulted loan is not cured by the end of the cure period or when a loan is otherwise defective in some way.
There are two aspects of deemed distributions that are often overlooked.
- There is no action required to trigger the tax liability. Just like a person’s paycheck is subject to income tax regardless of whether they get a W-2 at the end of the year, a deemed distributed loan is taxable even if no one takes steps to report it on a Form 1099-R. If the participant does not report the amount in question on his or her income tax return, it could generate additional penalties and interest for underpayment of income tax.
- A deemed distribution does not extinguish the participant’s obligation to repay the loan. In other words, a deemed distributed loan is taxable (and may include a 10% early withdrawal penalty), but the participant must still repay it. To make matters worse, those post-deemed-distribution loan payments create tax basis in the plan and must be tracked as a separate money source on the recordkeeping system.
Offset
A deemed distributed loan continues to be included as a plan asset until the participant in question has a distributable event, usually termination of employment. At that time, the outstanding balance is offset and reported on the plan’s financial statements as an actual distribution.
Examples of Good Loans Gone Bad
Now that we have reviewed the rules and defined some key terms, it is time to review some of the more common situations that can cause a good loan to go bad.
Loans Not Permitted
Plans are not required to offer loans but those that wish to allow loans must be sure the appropriate provisions are included in the plan document and/or separate written loan policy. Plan sponsors may believe they are helping a participant in need of cash by approving a loan request without going to the formality of amending the plan document; however, issuing a loan when the plan does not allow it results in a loan that never becomes good. The full amount of the loan is immediately deemed distributed.
Generally, a plan can offer loans at any point during the year as long as an amendment is adopted by the end of that year to add the necessary language to the plan document. However, once the year closes, there are fewer options for correction.
Refinancing Not Permitted
When homeowners wish to change their mortgage to get a lower interest rate or borrow additional money, they do so by refinancing their mortgage. Participant loans operate the same way. In order to change the terms of a loan, the participant must refinance it. The trick is that not all plans permit refinancing. Furthermore, inability to refinance is not always crystal clear. Consider a plan that permits loans but restricts participants to only one loan at a time. IRS regulations (and the U.S. Tax Court) look at certain refinancing transactions as consisting of two loans–the replacement loan (the new one) and the replaced loan (the old one). Therefore, the refinance transaction violates the one loan at a time limit, and the replacement loan is a deemed distribution. This can be addressed by amending the loan provisions to specifically permit refinancing or to allow multiple loans.
Loan Term Too Long
If a loan is amortized for longer than permitted, it is defective from the moment it is issued and the entire amount is a deemed distribution. A common example of this is when a plan issues a general purpose loan for longer than five years. Since that is a regulatory limit, this type of defect cannot be remedied by amending the plan to allow a longer amortization.
On the other hand, if a particular plan elects to limit all loans to only five years but issues a residential loan with a longer amortization period, it may be possible to amend the plan within the time frame described above.
Payments Never Started
Sometimes a participant takes a loan that is to be repaid by payroll deduction, but the payroll system does not get set up to begin withholding payments. Although there is some latitude, payments should begin within one or two pay periods following issuance of the loan. If that does not occur, the loan goes into default. Unlike the previous examples, this does not cause the entire loan to be defective. Rather, the participant has until the end of the cure period to get principal and accrued interest payments up to date and avoid a deemed distribution.
Payments Voluntarily Suspended or Discontinued
In other circumstances, a participant with a loan determines that he or she can no longer afford to make payments and asks the company to stop withholding on a temporary or permanent basis. Some employers may be inclined to help an employee in that situation by agreeing to the request. Unfortunately, doing so causes the loan to default (and maybe become a deemed distribution), and it also subjects plan fiduciaries to liability for breaching their responsibility.
Even though the participant is borrowing from his or her own account balance, the loan is still considered an asset of the plan. By voluntarily discontinuing the withholding of payments, the plan sponsor fails to enforce a legal agreement between the plan and the participant and allows a plan asset to decrease in value.
Coming Back to the Light
Fortunately, many loans that have crossed over can be brought back to the light. The IRS Employee Plans Compliance Resolution System (EPCRS) includes a series of voluntary correction mechanisms, including several for participant loans. Generally, defective loans are corrected by reforming them so that they comply with the applicable rules. Depending on the circumstances, other correction options may also be available. This could include retroactively amending a plan (effective in a previous year) to permit a loan that was issued in error.
Unlike other types of oversights, EPCRS does not permit self-correction. In other words, bringing a bad loan back from the dark side requires submitting documentation of the correction to the IRS for their approval.
Conclusion
As you can see, the participant loan rules can be challenging even in good economic times. With all of the potential missteps that can occur, it is important to work with knowledgeable service providers that have strong checks and balances designed to properly administer participant loans. By also implementing similar controls internally, plan sponsors can make sure that good loans don’t go bad.
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.
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.
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Spring will arrive soon, promising new growth and a fresh beginning. It could also be the perfect time to do some spring cleaning for your plan. Let’s look at some areas that you might consider reviewing to ensure your retirement plan is operating efficiently.
Document your processes and procedures to make certain that plan tasks can be handled in case of any absences during an enrollment or pay period. Having a backup in place can prevent errors and delays that could lead to penalties.
Make sure to have a process in place to notify all new enrollments of their eligibility, regardless of whether the plan has automatic enrollment. Depending on the timing for plan entry, including the plan enrollment paperwork with the new hire paperwork could make entry easier for you. Please reach out with any questions regarding when an employee enters the plan.
Deposits of employee deferrals and loan repayments must be submitted to the plan as soon as possible to avoid penalties and corrections. For plans with less than 100 participants, a safe harbor rule allows deposits to be made within seven business days. For larger plans, the expectation is that the money will be deposited more quickly. Depositing these funds on the pay date will avoid the possibility of being late.
Monitoring deferral contribution limits during the calendar year will avoid refunds after year end. Make sure that your payroll is set up to stop deferrals once the limit is reached, including any catch-up contributions for those who have reached age 50.
To keep the plan in compliance, employer contributions must be deposited timely. Due dates are impacted by the type of contributions, required status and tax deductibility. If you have questions on when to deposit your employer contribution or even whether to make an employer contribution, please contact us.
Most plans must be covered by a fidelity bond. The minimum coverage is 10% of plan assets (rounded up to the next $1,000) and the maximum coverage is $500,000. Additional requirements apply to plans with employer securities or non-publicly traded assets. If your fidelity bond is insufficient, now is the time to raise the coverage. Inflation clauses that increase the bond amount as the plan assets increase can ensure that your bond coverage is always adequate. Contact us or your insurance provider if you don’t have a fidelity bond.
Another area to review is communication with participants. Helping your employees understand and trust the plan can increase their contributions. Be sure that your procedures include distributing any plan-related communications—including required participant notices.
Distributions also involve communication, including some of the aforementioned notices. Discussing distribution options with terminated participants, possibly as part of an exit interview, can help to reduce risk of lost participants. We’ll provide instruction on distributions for force-out distributions for small balances, testing corrections and required minimum distributions.
Your plan document is the legal source on how the plan should be administered; operating within its parameters is critical. It’s always worth taking time to review the plan document to ensure that you fully understand and are following its provisions. We’ll cover more details about the plan document later in this newsletter. We’re here to support you in keeping your plan in compliance. Please feel free to reach out with any questions.
Addressing the Challenge of Uncashed Distribution Checks
Uncashed distribution checks present a persistent and often overlooked challenge for retirement plan sponsors. Despite the best efforts of plan administrators, some participants fail to cash their distribution checks, leading to administrative burdens, fiduciary concerns and potential compliance issues. A recent publication by Retirement Management Services (RMS) sheds light on this issue and offers practical guidance for employers seeking to manage and mitigate the risks associated with uncashed checks.
Uncashed checks can arise for various reasons. Participants may have moved without updating their contact information, may not recognize the check as legitimate or may simply forget to deposit it. Regardless of the cause, the responsibility for addressing these uncashed funds ultimately falls on the plan sponsor. This creates a fiduciary obligation to act in the best interest of the participant while ensuring compliance with IRS and Department of Labor (DOL) regulations.
Sponsors are encouraged to maintain up-to-date contact information for all plan participants and to follow up promptly when checks remain uncashed. This may involve sending reminder letters, making phone calls or using certified mail to confirm receipt. In some cases, plan sponsors may also consider using electronic payment methods to reduce the likelihood of checks going uncashed in the first place.
The IRS and DOL have issued guidance on how to handle these situations, including the use of forfeiture accounts and escheatment to state unclaimed property programs. However, these options come with their own set of rules and potential pitfalls. For example, using a forfeiture account may require the plan document to explicitly allow for such treatment. Escheatment laws, which allow the government to assume control of unclaimed property, vary by state. As such, plan sponsors must carefully evaluate their options and consult with legal or compliance experts as needed.
Another important consideration is the documentation of all the efforts made to contact participants and resolve uncashed checks. Maintaining a clear audit trail can help demonstrate fiduciary prudence and protect the plan sponsor in the event of an audit or legal challenge. It is extremely important to have a written policy in place that outlines the steps to be taken when a check remains uncashed beyond a certain period.
By taking a proactive, well-documented and compliant approach, employers can fulfill their fiduciary duties, reduce administrative burdens and ensure that participants receive the benefits they are entitled to.
Source: Retirement Management Services – “Uncashed Distribution Checks” https://www.consultrms.com/Resources/59/Plan-Sponsor-Tips-and-Help/212/Uncashed-Distribution-Checks
Divorce and the Retirement Plan
When a participant in a qualified retirement plan undergoes a divorce, the participant’s account balance may be an asset that is split with the former spouse. As the plan exists for the exclusive benefit of its participants, a court order is required to transfer the participant’s benefits to the ex-spouse. Once approved by the plan administrator, this court order is called a Qualified Domestic Relations Order (QDRO).
The QDRO is a judgment, decree or order that must be issued by a state authority (usually a court). It can be part of the divorce settlement or it may be a separate document. Because of the serious nature of separating the participant’s account balance, the QDRO is more than just an agreement made by both parties — it must also be signed by a judge.
A QDRO will describe how to divide the participant’s account balance between the participant and the ex-spouse, referred to as the alternate payee. In some cases, a set dollar amount will be allocated; in others, a percentage of the account may be designated. In the latter case, the amount assigned to the alternate payee represents the given percentage of the participant’s total vested account balance as of a specified valuation date. This percentage will apply to all sources — such as deferrals, matching or profit sharing — unless specified by the QDRO. Any interest and investment gains/losses that accrue between this valuation date and the date the funds are separated into an account for the alternate payee are often factored into this final calculation. If the participant has outstanding loans, the QDRO will usually indicate how the loans are handled.
Contributions such as deferrals and employer matching made after the valuation date are credited to the participant’s account. Earnings and losses are applied to the account balances. Once the division is complete, the alternate payee’s portion (either dollars or shares) is transferred to an account in the alternate payee’s name.
If the plan allows, the alternate payee may be paid out in a cash or rollover distribution. Not all plan documents allow the alternate payee to receive a distribution before reaching normal retirement age, so it’s important to follow the terms of the plan. In addition, the QDRO cannot violate the provisions of the plan document by requiring a plan to provide an alternate payee or participant with any type or form of benefit not otherwise provided under the plan.
Although the most common situation for a QDRO is a divorce, it can be issued in other situations, such as to a dependent in the case of child support. If the alternate payee is a minor child or legally incompetent, the order can also require payment to the individual with legal responsibility for the alternate payee. If a participant or their attorney provides you with a copy of a divorce decree that references the plan or a QDRO, please contact us immediately, and we will work with you to ensure it meets the requirements of the plan.
Important note for defined benefit plans: For 2025 plan years, PBGC premiums are due one month earlier than usual, specifically on the 15th day of the ninth month after the beginning of the plan year. For calendar year plans, this means the premium is due on September 15, 2025, instead of the usual October 15. This accelerated deadline is due to a provision in the Bipartisan Budget Act of 2015.
Upcoming Compliance Deadlines for Calendar-Year Plans
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