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Participant Loans: Important Considerations

Practice Management

Editor’s Note: This is the second installment in a two-part series on participant loans. It discusses the insights and suggestions of Joni Jennings, Retirement Services Compliance Manager at Newfront. The first appears here

Many retirement plans allow participants to take loans from their accounts. But that entails more than simply deciding to allow participants to do so — that is only the beginning. There are procedures that must be followed, and important considerations that flow from that initial choice. 

Following are some additional questions and matters concerning plan loans that Joni Jennings, Retirement Services Compliance Manager at Newfront, suggests employers consider in “401(k)ology — Participant Loans (Part 1).” 

The Effect of a Deemed Distribution of a Loan on a Plan

Jennings notes that a loan is outstanding and owed to the plan, and that the balance is a plan asset as long as the participant is an employee. That matters, she says because most of the time active participants have not earned the right to a distribution yet, and a participant must repay the loan. 

Whether a participant can take another loan while one is already outstanding, Jennings continues, depends on whether the plan allows it. But even if the loan policy does allow participants to have more than one loan at a time, a plan fiduciary should be careful since granting a second loan to a participant who has defaulted on a loan could be regarded as circumventing distribution provisions. 

Whether it is prudent to allow an active employee who has defaulted on a loan to take a second one is probably a facts-and-circumstances determination, she says. Jennings suggests that “it may be prudent” to have the loan policy indicate that if a participant who has a loan in default, the application could be denied if he or she is in default with another loan. 

Repayments by Active Participants Who Have Loans Deemed Taxable

An active participant who has a loan that is deemed taxable not only can repay the loan, Jennings notes, he or she is obliged to do so. Loan repayments, she notes, would be considered “after-tax” and must be tracked separately to make sure that the participant is not taxed on the same distribution twice. 

Enforcing Loan Repayments

If one of the conditions under which a loan is made to a participant is that repayments are made by after-tax payroll deduction, then the plan fiduciary must collect the repayments, Jennings writes. 

But there are complications, Jennings notes. Circumstances such as state law may prevent such a repayment arrangement. And in states where ERISA does not preempt state law regarding voluntary payroll deductions, employers must follow the employee’s direction to stop them.

Additional Fiduciary Considerations

Jennings notes that the IRS — through its role with taxation and participants — and the Department of Labor — through its role in enforcing the rules concerning prohibited transactions and fiduciaries — have a role in enforcing the rules concerning participant loans.

Participant loans must be reported on a plan’s Form 5500, Jennings observes, and cautions that if a plan reports deemed distributions, that may heighten the possibility that the plan may be audited.