Participant Loans: More to Consider Than Meets the Eye

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

To include the ability of participants to take loans from their 401(k)s in the plan or not? That is the fundamental question facing an employer regarding loans and the plan, but by no means is it all an employer should be considering, suggests a compliance manager. 

Deciding whether or not to include language in the plan that allows participants to take loans is only the beginning, argues Joni Jennings, Retirement Services Compliance Manager at Newfront, in “401(k)ology — Participant Loans (Part 1).” 

“The decision-making process to include loans in the 401(k) plan frequently comes down to a basic ‘yes/no’ question when the employer is completing the plan’s adoption agreement,” Jennings says, but after that, many employers do not continue and then consider the parameters of a loan program — such as how many loans a participant may have outstanding at one time, the interest charged and the minimum loan amount. “These are significant compliance and fiduciary related matters that employers should consider when deciding whether to include a participant loan program in the company 401(k),” she writes. 

Follow the Rules

Jennings notes that there are three rules that are especially important concerning participant loans. 

1. Anti-alienation. Generally, 401(k) plan benefits must only be used for retirement benefits; however, participant loans secured by a participant’s vested account balance and are not prohibited transactions are an exception to that rule.

2. Prohibited Transactions. Qualified plans cannot make loans to disqualified persons unless there is a prohibited transaction exemption.

3. Taxable Distributions. Distributions from a 401(k) generally are taxable. But that does not apply to participant loans from a 401(k) as long as the maximum loan outstanding is the lesser of $50,000 or half of the participant’s vested balance and the participant repays the loan within five years — although the participant may take longer than that if he or she used it to buy a primary residence. 

The Plan Document

Jennings suggests that, regarding plan loans, a plan document include provisions such as: 

• stating that loans to participants are allowed;
• setting forth that plan fiduciaries are responsible for establishing a written loan policy; and
• specific parameters for the loans. 

Plan Loan Policy 

A plan document, Jennings explains, generally will include language stating that loans from participants’ 401(k)s will be permitted, and will include a loan policy which will set parameters for them. Such a policy, she says, is a “first line of defense” against participant loan errors and will help in making sure that participant loans are properly maintained. 

A loan policy, Jennings says, is considered to be an extension of a plan document. She notes that it must be in writing and be provided to plan participants. Many practitioners include the plan loan policy in the summary plan description (SPD) or as an addendum to it, she adds.

Jennings suggests that these provisions be part of a loan policy:

• spelling out who has authority to administer the loan program;
• the types of loans allowed;
• the amount that can be taken in a loan, and what the minimum loan amount is;
• the parameters for loans to be used for a primary residence;
• discussion of how interest rates will be determined;
• the collateral used to secure a loan;
• the maximum number of outstanding loans a participant may have; 
• whether refinancing is allowed, and if so, what the options are; 
• fees; 
• application procedures;
• loan approval and denial processes;
• a requirement that a participant sign a promissory note;
• how a participant is to repay a loan; and 
• the loan default and cure period.

The Bottom Line

Jennings urges that an employer be aware of the rules, and put policies and procedures in place to maintain the program. 

It is of utmost importance, Jennings cautions, that plan sponsors fulfill their responsibility to comply with legal requirements that govern participant loans. Failure to do so, she warns, could result in participants who borrow being taxed as well as plan fiduciaries engaging in a prohibited transaction. 

Next Installment: Additional considerations surrounding plan loans