In last month’s 401(k) Compliance Check, we discussed the importance of developing (and maintaining) best practices for handling beneficiary designations. This month, we discuss one of the most common problems faced by 401(k) plan administrators1 – errors involving retirement plan loans.
Why is This Topic Important?
Industry data from 2019 shows that 85% of defined contribution plan participants had access to plan loans. Further, as of the end of March 2022, 12.5% of all such participants had outstanding loan balances. With around 60 million Americans actively participating in 401(k) plans, that’s a lot of plan loans – and a lot of opportunities for administrative errors.
Failing to correct plan loan errors can lead to adverse consequences for both plan loan recipients and the plan itself, including loss of the plan’s tax-qualified status. Luckily, changes to the IRS’s EPCRS correction program have made correcting certain common plan loan mistakes simpler and less costly.
Back to Basics – Plan Loan Rules
As a starting point, we’ll review the retirement plan loan rules under Internal Revenue Code (Code) Section 72(p) and the related Treasury Regulations. Plan loans will be treated as taxable distributions from a plan unless they satisfy these rules:
- Loans must be permitted by the plan document2 and should be available to all participants and beneficiaries on a reasonably equivalent basis.
- Loans must be evidenced by a legally enforceable agreement (either in hard copy or electronic format3).
- Loans can’t exceed the lesser of (a) 50% of the participant’s vested plan account balance or (b) $50,000.4 The maximum loan amount will be reduced by the outstanding balance on any prior loan(s).
- Loans must be secured by the vested assets in the participant’s plan account and provide for a commercially-reasonable interest rate.
- Loans must be repaid through substantially level repayments on at least a quarterly basis.
- Loans must generally be repaid within five years (exceptions may apply for loans used to purchase a primary residence and to address certain leaves of absence).
Correction under the IRS’s EPCRS
The IRS’s Employee Plans Compliance Resolution System (EPCRS) correction program offers plan sponsors a means to correct various operational errors, including plan loan errors. Before 2019, plan loan failures had to be corrected using the EPCRS’s voluntary compliance program (VCP). Plan sponsors using the VCP to correct such failures were required to: (i) submit an application describing the failure and its correction, and (ii) pay a compliance fee.
Failures that can be corrected using the EPCRS’s self-correction program (SCP). In 2019, however, the IRS expanded the EPCRS to permit self-correction of these plan loan errors:
- Missed payments leading to a defaulted plan loan – i.e., situations where a participant fails to repay his/her plan loan in accordance with its terms.
- Failure to obtain spousal consent for a plan loan.
- Obtaining more plan loans than the plan permits.
- Reporting of deemed distributions.
Failures that must be corrected using the VCP. The EPCRS requires these plan loan failures to be corrected using the VCP process: (i) loans for amounts in excess of the maximum dollar limits, (ii) loans with repayment schedules longer than the permitted period, and (iii) loans permitting repayment on a schedule not allowing for level amortization or at least quarterly repayments.
Plan loan errors not described specifically in the EPCRS may be corrected using general EPCRS correction principles and procedures.
Correcting Common Loan Errors
The EPCRS describes the correction methods for various loan errors. Discussion of all the correction methods is beyond the scope of this article. The correction procedures for a few errors our clients commonly encounter are, however, discussed below.
Missed Payments/Defaults. For various reasons,5 plan participants may sometimes get behind on their loan payments. If the loan is already in default due to the missed payments – i.e., past the deadline of any “cure period” the plan’s loan program may provide, the error can be self-corrected so long as the loan terms otherwise comply with the loan requirements described above.
A participant’s failure to repay his/her plan loan as required can be corrected by:
(i) the participant making a lump sum payment to the plan equal to the missed loan payments, plus interest;
(ii) re-amortizing the loan’s outstanding balance, including any accrued interest, over the remaining term of the original loan or over the maximum loan period permitted by the Code Section 72(p) (measured from the loan’s origination date); or
(iii) a combination of (i) and (ii).
This error can be corrected in this manner only if the participant agrees to take one of the actions described above, and only if the maximum loan repayment period hasn’t expired. If the error is corrected, the default will not be treated as a “deemed distribution”6 reportable on Form 1099-R.
If the error is not (or cannot be) fully corrected, a deemed distribution will occur and must be reported on Form 1099-R. The plan sponsor should report the deemed distribution in the year of correction, rather than in the year of the error.
Too Many Plan Loans. A plan’s loan policy will typically set forth the maximum number of loans a participant can have outstanding at any particular time. Occasionally, however, an administrative error will result in a participant obtaining loans in excess of the maximum number permitted by the plan.
To correct this error, the plan sponsor must adopt a retroactive amendment conforming the plan document to the plan’s actual administration.7 The retroactive amendment must otherwise be permitted under the Code, and the plan’s loan provisions, as amended, must meet the IRS’s plan loan requirements. Further, loans in excess of the plan’s limits must have been available to all plan participants, or one or more non-highly compensated participants.
Loans Exceeding the Maximum Term. Sometimes, an otherwise compliant loan will be issued with a loan term that exceeds the maximum permitted. For instance, a loan not being used to purchase a primary residence might be issued with a 10-year term, rather than the maximum five-year term that should apply.
This error may be corrected by re-amortizing the loan’s remaining balance over a remaining period that does not exceed the loan’s maximum permissible term (starting from the loan’s origination date). If it’s possible to correct the error in this manner, the participant’s loan payments will increase for the remainder of the term. If re-amortization isn’t possible,8 the unpaid balance of the loan will be treated as a deemed distribution and reported in the year of correction (rather than in the year the loan was initially issued).
While this failure must be corrected using the EPCRS’s VCP process (rather than through self-correction), plan sponsors may be eligible to use the IRS’s “streamlined” VCP form to do so. Using the streamlined VCP process should make filing the application simpler for the plan sponsor.
Avoiding Loan Errors in the First Place
The IRS offers plan sponsors a list of procedures for avoiding plan loan mistakes. At the heart of that advice is the need for plan sponsors to:
- take care when establishing a 401(k) plan loan program, including carefully reviewing any required forms, loan policies, and other documentation;
- implement a system for monitoring the administration of the loan program, requesting periodic reports from plan vendors, and spot-checking loan paperwork to ensure ongoing compliance with IRS requirements; and
- identify and correct any administrative errors as quickly as possible.
When it comes to avoiding 401(k) plan loan errors, the best offense really is a good defense.
1 Plan loan errors can also plague the sponsors of Code Section 403(b), profit sharing, money purchase, and governmental Code Section 457(b) plans offering plan loans. The discussion in this article also applies to those plans.
2 A 401(k) plan document won’t typically include a detailed description of the plan’s loan program. Instead, plans often direct readers to a separate, comprehensive loan policy for any needed details. See our July, 2022 401(k) Compliance Check regarding the information typically included in such policies.
3 Loans may not, however, be made through credit cards.
4 Exceptions may apply. For instance, for a limited period in 2020, the Coronavirus Aid Relief and Economic Security (CARES) Act of 2020 permitted plan participants affected by the COVID-19 pandemic to borrow up to the lesser of (i) 100% of their vested plan accounts or (ii) $100,000.
5 Among other reasons, missed or late payments may occur due to (i) administrative errors in coding participant payments, (ii) errors related to participant leaves of absence, and (iii) errors due to a participant’s move from a full- to part-time schedule, etc.
6 A “deemed distribution” occurs if a plan loan fails to meet the plan loan requirements, including the requirement to repay the loan on a regular basis. In that case, the outstanding portion of the loan, including any accrued but unpaid interest, is treated as distribution to the participant. The deemed distribution is reportable in the participant’s income and may be subject to early withdrawal penalties (if the participant is under age 59 ½).
7 A retroactive amendment may also be used to correct a situation where a plan that doesn’t permit loans by its terms inadvertently allows a participant to take one.
8 This might occur, for instance, if a loan was issued with an impermissible 10-year term, but the participant had already been paying for six years.