Pension Administration and Trust Accounting, PATA  Pension Administration and Trust Accounting                                                                                      



                                             
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         Ipswich, MA  01938
         978.356.9004
         (f) 978.418.9178

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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.