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Complete Pension administration for closely held corporations, sole
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PENSION
ADMINISTRATION and TRUST ACCOUNTING
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 that 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.
It is no surprise
given the current state of our economy 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.