PlanFacts

How to Find, Fix and Avoid Plan Loan Mistakes

Plan loans are a popular feature of 401(k) and other retirement plans. Workers may be more likely to save for retirement in an employer sponsored plan if they know they can access their savings during their working years. And if they do need to do so, a plan loan enables them to restore their savings, with interest, back to their retirement plan account. 

Plan sponsors who choose to include a loan feature in their retirement plan must take care to ensure their loan program is operated in compliance with the tax rules and the plan’s loan policies to avoid unintended consequences for loan recipients and the plan. To help you keep your loan program in compliance, here’s an overview of the basic rules for plan loans and some best practices for finding, fixing and avoiding plan loan mistakes.

Plan Loan Rules

A 401(k) plan may allow plan participants (including business owners) to take loans from their vested plan assets. Plan loans must meet the regulatory requirements to avoid being treated as a taxable distribution from the plan. These include:
 

  • written loan agreement between the plan and the participant 
  • a commercially reasonable interest rate
  • loan repayments in substantially level payments at least quarterly  
  • five-year maximum repayment period (unless loan is used to purchase a primary residence) 
  • loan amount does not exceed 50% of the participant’s vested account balance, or $50,000, whichever amount is less; the maximum loan amount must be further reduced if the participant had any outstanding loans within 12 months prior to the loan 

Plan sponsors may place additional restrictions on plan loans, such as requiring loans to be paid through payroll deduction and limiting the number of loans participants can have at one time.  

Loan Defaults and Other Loan Failures

If required loan payments are not made, the loan may go into default. Upon default, the outstanding loan balance will be treated as a taxable distribution and reported on IRS Form 1099-R. If the participant is younger than age 59½, the taxable amount will also be subject to the 10% early distribution tax unless the participant meets an exception. 

A plan may provide that a loan is not in default until the end of the calendar quarter following the quarter in which the payment was missed (called a “cure period”). There also may be temporary repayment relief available for those on military leave, other leaves of absence, or those in a federally declared disaster area.

In addition to loan defaults, all or part of a loan may become taxable if the other loan rules are not followed, for example, if a loan exceeds the maximum permissible loan amount or provides for repayment over a period extending beyond the maximum permissible loan repayment term.

Fixing Mistakes

Employers who discover loan errors in their plan may fix the errors under the Employee Plans Compliance Resolution System (EPCRS) of the IRS. This allows many different types of plan qualification failures, including loan failures, to be corrected. Historically, loan failures could only be corrected by submitting a formal application under the Voluntary Compliance Program of EPCRS and paying the required fee (ranging from $1,500 to $3,500 for 2019). However, effective April 19, 2019, certain plan loan failures may now be corrected under the Self-Correction Program of EPCRS without contacting the IRS or paying a user fee.¹  

To correct under the Self-Correction Program, the employer must have practices and procedures in place that are designed to promote overall compliance in form and operation with applicable IRS rules. Note, however, that any prohibited transaction concerns a defaulted loan may present may only be fully addressed by correcting the loan through the Voluntary Compliance Program.

The following table summarizes common plan errors and the permissible methods of correcting under EPCRS: 



Administering plan loans typically involves multiple people from several organizations, including your human resources staff, your payroll provider, and a third party administrator or recordkeeper. Mistakes are bound to happen. To help uncover any existing loan errors, the IRS recommends that plan administrators review all outstanding loans to ensure they comply with the regulatory requirements and all repayments have been made in a timely manner.² This may include reviewing the loan agreements, loan amount, interest rate, repayment term and schedule, and history of payments made for each outstanding loan.

To avoid plan loan mistakes in the future, the IRS recommends plan sponsors establish internal controls to ensure loans are administered in compliance with the tax laws and the plan’s loan policy. Some of the internal controls the IRS has identified for ensuring compliance include developing the following tools:²
 

  • a system for determining the participant’s maximum loan amount during the loan approval process (must consider plan terms, the participant’s account balance and prior loan history)
  • procedures for monitoring loan repayments to ensure that the withheld amounts are properly determined and deposited to the plan timely 
  • a process for tracking the cure period for participants who are in default 

Newport Group has extensive experience administering retirement plan loans and repayments. Our processes are designed to foster compliance with applicable loan rules. If you have any questions about the loan rules, contact your Newport Group Relationship Manager.

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¹IRS, Expanded Self Correction Program, EPCRS Rev. Proc. 2019-19, https://www.irs.gov/retirement-plans/expanded-self-correction-program-epcrs-rev-proc-2019-19

²IRS website, 401(k) Plan Fix-It Guide – Participant loans don’t conform to the requirements of the plan document and IRC Section 72(p), February 7, 2019, https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-participant-loans-do-not-conform-to-the-requirements-of-the-plan-document-and-irc-section-72p  

Disclaimers

For informational use only.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before making any decisions.


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Newport Group, Inc. and its affiliates provide recordkeeping, plan administration, trust and custody, consulting, fiduciary consulting, insurance and brokerage services. Fiduciary consulting services are provided through Newport Group Securities, Inc., an SEC-registered investment adviser and FINRA-registered broker-dealer, and Newport Group Consulting, LLC, an SEC-registered investment adviser. Newport Group Securities, Inc. and Newport Group Consulting, LLC are affiliates of Newport Group, Inc. All securities transactions are provided through Newport Group Securities, Inc., in its role as broker-dealer. All fiduciary consulting services are provided through the registered investment advisers. When offering variable insurance products, Newport Group Securities, Inc. acts solely in its capacity as a broker-dealer. Trust and custody services provided by Newport Trust Company, a New Hampshire state chartered trust company and wholly owned subsidiary of Newport Group, Inc.