Lamenting over loans: Operational failures related to participant plan loans
A guide to resolving common issues with defined contribution plan administration
Defined contribution retirement plans are a complex entanglement of many moving parts and players that can change at any moment.
In our first article, we discussed the general rules and principles surrounding qualified retirement plan operational failures. This article will explore possible corrections when a participant plan loan doesn’t go exactly as it should.
Participant loans from a qualified retirement plan can enable participants to temporarily borrow funds from their retirement account instead of taking a withdrawal. This can provide them with the short-term relief needed for an emergency or expenditure, while providing a way for them to replenish their account over time. Not all financial experts are fans of plan loans, but they are a reality and heavily utilized by participants.
Retirement plans that offer participant loans are required to define the loan terms in either the plan document or a separate loan policy. The loan terms govern distribution, amortization, and repayment of the participant loan to ensure that all Internal Revenue Code (IRC) requirements are met to avoid taxation under IRC Section 72(p). Additionally, plans can limit the number, amount, and reason for participant loans.
Issues with plan loans represent a common operational failure, #9 in the IRS 401(k) Fix-it Guide. In early 2019, correction of plan loans involving 72(p) errors was addressed in the IRS Employee Plans Compliance Resolution System (EPCRS) using the Self-Correction Program (SCP). Prior to this, loan errors were only correctible under the Voluntary Correction Program (VCP). For more information on the EPCRS, SCP, and VCP programs, please see our prior article “Imperfect Defined Contribution Plans: When Good Plans Go Bump.”
Special relief from the deemed distribution rules of IRC §72(p) is not available under SCP if the plan loan doesn’t comply with the IRC §72(p) maximum loan amount limit, maximum repayment term, or level amortization requirement. Correction of these failures may only be obtained via VCP or, if under IRS audit, the Audit Closing Agreement Program (Audit CAP).
Reasons loan failures occur
Plan loan failures can occur when the loan does not meet the requirements of IRC Section 72(p) when established, such as loan amount, collateral, or repayment period. This is relatively uncommon when a plan is working with a reputable recordkeeper or third-party administrator (TPA). However, if this does occur, the EPCRS allows for correction by reporting the deemed distribution on a Form 1099-R in the current year instead of in the year the original error occurred. If the loan error is based on the number of loans allowed, a retroactive amendment may be adopted to conform the document and policy in accordance to plan operation.
The most common issues occur around actual loan payments. Many plans require active participants to make loan payments through either payroll deduction or by establishing a regular Automated Clearing House (ACH) withdrawal with the recordkeeper. This is done to ensure that loan payments remain on track and are simpler to administer.
However, as we all know, things happen. Sometimes, due to participant, administrator, or sponsor issue, payments can be missed, and the loan can end up in arrears or default. Plan administrators or TPAs typically send arrears letters and communications to the plan sponsor and the participant to try to get the issue corrected and alleviate stress on the plan sponsor and the participant.
Cure period and consequences for missed payments
IRC §72(p) allows for a cure period following missed loan payments before a participant loan will default. This is generally recognized as the end of the calendar quarter following the calendar quarter of the missed payment. If no corrective loan payments are made before this cure period date, the participant loan will be considered a deemed distribution, resulting in current taxation to the participant.
If the participant is still actively employed, the amount of the deemed distribution will be taxable to the participant, but the loan obligation will continue, and the loan will remain a plan asset. This is because the deemed distribution treatment under IRC §72(p) is solely a tax rule and is not treated as an actual distribution from the plan. Thus, the deemed distribution does not affect the participant’s continued obligation to repay the loan.
The remaining outstanding loan may be repaid by the participant resuming loan payments, or through a “loan offset” against the participant’s vested account balance when the participant is eligible for an actual distribution from the plan. Consequently, if the plan only allows for one loan at a time, the participant will not be entitled to take a future loan until the deemed loan is repaid.
Repaying the post-deemed distribution loan obligation by resuming loan payments
Once there has been a taxable deemed distribution of a defaulted participant loan, the participant can resume making payments. However, in this instance, because the defaulted loan has been taxed, the loan payments will now be treated as after-tax amounts and will increase the nontaxable basis in the participant’s account.
Repaying the post-deemed distribution loan obligation by a loan offset
If, or when, the participant has a distributable event and is eligible for an actual distribution from the plan (for example, terminates employment or qualifies for an in-service distribution), the loan obligation then becomes a loan offset. With a loan offset, the plan is "distributing" the unpaid loan obligation, which represents a portion of the participant’s vested account balance. For this reason, a loan offset is treated as an actual distribution of the participant’s vested account, so it may not occur unless the participant qualifies for an actual distribution from the plan. After the loan offset, the loan obligation ceases, and the loan is no longer carried as a plan asset.
When there is a delay between the time of the deemed distribution and the loan offset, the previous taxation of the loan that occurred when the loan was deemed a distribution would determine the tax consequences of the loan offset. A Form 1099-R would be required to report any subsequent distributions.
After January 1, 2018, if the loan offset is due to plan termination or termination of employment, the participant will have an extended period to complete a rollover of cash equal to the amount of the loan offset to avoid current taxation, specifically, until the due date (including extensions) of the participant’s federal income tax return for the year of the loan offset.
Correcting defaulted or loans in arrears
As we mentioned before, participants miss loan payments for a variety of reasons. What are the options available to participants and plan sponsors with regard to correcting these loans? Based on the IRS guidance, there are various options available to the plan.
The easiest correction, as long as the participant has not incurred a deemed distribution and the participant is still within the cure period, is to have the participant make up all missed loan payments and bring the loan current. However, this often isn’t a feasible correction for the participant.
If the plan document loan policy allows, or if the plan will correct under the IRS EPCRS system, a participant may refinance the loan to increase the payments to allow the loan to be brought current and be paid off within the maximum loan period (generally five years from the loan issuance date unless the loan is to purchase a home).
If beneficial, a combination of these methods could be used to cure the loan.
It is important to remember that these corrections cannot be done without the participant’s consent. Also, the participant must be provided the new loan terms via a new promissory note and amortization schedule if refinancing the loan. As the participant originally indicated consent and agreement to the loan terms by signing the loan promissory note, legally the participant is responsible to ensure that loan payments begin and continue.
However, depending on the situation, some responsibility lies with the employer or plan sponsor if a participant loan goes into default. This may include missed payments resulting from payroll errors, incorrect payment setup in payroll system, or changes in payrolls. In these cases, the employer or plan sponsor will be responsible for making a corrective contribution to the participant’s account in an amount equal to the participant’s rate of return adjusted for the loan interest rate.
As you can see, plan loans can be complicated, especially when they don’t go as planned. Errors can cause tax implications to the participant and operational failures in the plan. It is important to keep an eye on the information provided to the plan by the recordkeeper or third-party administrator. Milliman routinely provides Human Resource Information Systems (HRIS) reports regarding new loans, loan payments in arrears, and defaulted or deemed loans. Monitoring payroll systems and having procedures in place surrounding plan loans is crucial. And when things go wrong—work to get them corrected right away. The less time that passes the easier and less onerous the correction will be.
For more information, please contact a Milliman Consultant or your Millman Service team.