401(k) Loans: Whether a Borrower or a Lender, Beware

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1 Retirement Perspectives 401(k) Loans: Whether a Borrower or a Lender, Beware April 4, 2014 Brian Dobbis, QKA, QPA, QPFC, T PGC Retirement Analyst, Institutional Investor Services A maze of rules applies to making and taking loans from employer-sponsored retirement plans. Take care to comply with them all. Many employer-sponsored retirement plans, such as 401(k)s, permit participants to take one or more loans from their accounts. To plan participants who have been dutifully contributing to their retirement funds, these accounts may represent a tempting source of ready money at competitive interest rates. However, even though the borrower pays back the loan plus interest to the borrower s own account, participants would be well advised to proceed with caution, since the participant may be viewed as, in effect, having lost much of the benefit of tax deferral on plan earnings (to the extent of the outstanding loans) that these plans generally provide. As of the end of 2011, an estimated 21% of 401(k) plan participants who had access to a loan feature took one. The average unpaid loan balance among plan borrowers represented about 14% of their 401(k) account balances (net of the unpaid loan balances), according to Department of Labor (DOL) data. In aggregate, outstanding loan amounts were less than 2% of 401(k) plan assets in 2010 (the latest year for which data are available), according to DOL data. Offering a loan provision is typically seen as a potentially useful plan benefit. After all, it provides plan participants with access to their account balance without being subject to current income taxes or penalties. But the consequences of this decision both for the participant taking out the loan and the plan sponsor that offers the benefit are not always clearly understood. It should come as little surprise, then, that retirement-plan loans, like retirement plans themselves, are heavily regulated and rigorously monitored. For both sides of the transaction, there are pitfalls to be avoided. For participants, there are several caveats that they should consider before taking a loan from their retirement accounts and the multiple rules they must follow once they do if they are to avoid unwanted consequences. For plan sponsors, retirement-plan loans involve paying rigorous attention to fiduciary oversight and recordkeeping requirements to ensure compliance with government rules and regulations. Under the Employee Retirement Income Security Act (ERISA) 408(b)(1) and the Internal Revenue Code (IRC) 72(p), loans are prohibited and may be treated as taxable distributions, respectively, unless certain requirements are met. Both the DOL and the Internal Revenue Service (IRS) have indicated that they are concerned about compliance with a number of rules governing loans. Nevertheless, a loan program structured correctly under the IRC can offer a number of advantages that are summarized below. 1

2 General rules and requirements Essentially, the regulations exist to distinguish a tax-free plan loan from a taxable distribution. Plan loans are not taxable distributions unless they fail to satisfy the plan and IRC rules. A plan loan may in effect become a taxable withdrawal if it is not repaid according to the loan terms. ERISA 408(b)(1) [and IRC 4975(d)(1)] allows for participant loans under the prohibited transaction rules, while 72(p) of the IRC contains the rules for taxation of participant loans. Here is a summary of the general requirements that apply to participant loans: Loans must be available to all participants on a reasonable equivalent basis. Loans may not be made available to highly compensated employees in an amount greater than the amounts made available to other participants. Loans must be made in accordance with written plan provisions. Loans must bear a reasonable rate of interest. Loans must be adequately secured. The maximum amount a participant may borrow is 50% of his or her vested account balance, or $50,000, whichever is less. Loans are repayable within five years, except for loans to acquire the principal residence of the participant. Loans for a home purchase can have a significantly longer repayment period. Principal and interest are amortized in level amounts payable not less than quarterly. Loans must be made under the terms of a legally enforceable agreement, including the dates and amounts of the loan and repayment schedule. 2

3 As you can see, there are a number of rules to satisfy in order for a loan to not be treated as a taxable distribution at the time it is made. Failure to comply can have significant tax implications for the participant and consequences for the plan sponsor as well. General economic/financial considerations While the borrower does repay the borrower s own plan account, there can nevertheless be some significant adverse financial effects that can arise in connection with the taking of a loan from the plan. Generally, any increase from time to time in the value of the assets in plan accounts accumulates on a tax-deferred basis, and the taking of a loan from the plan can have the practical effect of causing the participant to lose the benefit of that tax deferral. Participants should try to understand the potential tax and other economic ramifications surrounding a decision to take a loan (with the help of their own tax and other advisors, as they see fit) before proceeding with any decision to take a plan loan. Consequences of a default A 401(k) plan loan is commonly established on a five-year repayment schedule, with payments made at least quarterly. A plan can provide for a cure or grace period for missed payments, preventing a default. The maximum cure period allowed is the last day of the quarter following the missed payment. This gives the borrower the ability to defer payment due on June 30 of a given year to December 31 of the same year. The plan also has the option of implementing a shorter cure period. Once the cure period has ended, the loan is in default, and, therefore, the plan generally must report the defaulted loan on IRS Form 1099-R. There are situations, including military service and bona fide leaves of absence, whereby a participant can defer or extend loan payments without incurring a default. A plan loan that satisfies the requirements of 72(p) is not treated as a taxable distribution. However, should a plan participant fail to satisfy any loan requirements, a default will occur. Defaulting on a plan loan can cause either a deemed distribution or a loan offset. A loan offset occurs when the participant defaults on the loan upon experiencing a distributable event, such as separation from service, causing loan payments to be paid at a faster pace. The plan will offset the loan by reducing the participant s account balance by the amount of the outstanding loan obligation. In other words, the loan is considered closed and no longer part of the participant s account balance. The IRS considers an offset to be an actual distribution reportable as income on Form 1099-R. Moreover, the offset is subject to the 10% early distribution penalty unless an exception applies, if the participant is younger than 59½. A loan offset is generally treated as an eligible rollover distribution. Often a plan is unable to offset a loan because the participant has not encountered a distributable event (e.g., separation from service) that would allow an offset. In such cases, the plan reports the defaulted loan as a deemed distribution and reports the transaction on Form 1099-R. Later, when the participant experiences a distributable event, the plan will offset the loan. A deemed distribution, such as the offset, is subject to the 10% early withdrawal penalty unless an exception applies, if the participant is younger than 59½. A deemed distribution, unlike an offset, is generally not eligible to be rolled over. Potential plan disqualification Although it s not common, it is not outside the realm of possibility for a plan to be disqualified for mishandling participant loans. The IRS offers a correction program, the Employee Plans Compliance Resolution System, for handling loan problems. Further, the IRS also offers fix-it guides to help plan sponsors find, fix, and avoid common mistakes. There are other basic rules that sponsors need to heed. Among them: 3

4 Plans can, but are not required to, permit more than one outstanding loan to the same participant at the same time. Plans may, but are not required to, permit participants to make loan payments via payroll deduction. Loan repayments can be suspended only for up to one year for a leave of absence that is not due to military leave. A plan may require the spouse to consent to a loan. Plans are permitted to set a minimum loan amount (often $1,000) at their discretion (subject to possible nondiscrimination concerns). IRAs, including SIMPLE and SEP plans, are prohibited from allowing plan loans. Loan origination and maintenance fees are common. Plan loan rules are set forth in the plan document and Summary Plan Description. Plan loans are often subject to particular IRS and DOL scrutiny during audits. Conclusion Offering a loan provision gives plan participants the ability to access their account potentially without being subject to taxes and/or penalties and to repay themselves at relatively low rates. But these loans are not a panacea. The tax implications of a loan default, the possibility of IRS penalties and sanctions, and the potential for plan disqualification provide disincentives for taking out or offering loans. Those who sponsor 401(k) plans for their employees should understand that loan provisions are not benign. Loans can complicate plan administration, increase the probability of errors, and burden plans with additional and unwanted costs. This material is provided only for general and educational purposes and is not intended to provide legal, tax, or investment advice or for use to avoid penalties that may be imposed under U.S. federal tax laws. Contact your attorney or tax advisor regarding your specific legal, investment, or tax situation. The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast or as research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at or visit us at lordabbett.com. Read the prospectus carefully before you invest. 4

5 Investors should carefully consider the investment objectives, risks, charges and expenses of the Lord Abbett Funds. This and other important information is contained in the fund's summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, you can click here or contact your investment professional or Lord Abbett Distributor LLC at Read the prospectus carefully before you invest or send money. Not FDIC-Insured. May lose value. Not guaranteed by any bank. Copyright 2014 Lord, Abbett & Co. LLC. All rights reserved. Lord Abbett mutual funds are distributed by Lord Abbett Distributor LLC. For U.S. residents only. 5