401(k) Loan Policies – What to Consider

< Back to Insights
Insights  <  401(k) Loan Policies – What to Consider

Although it is not required by law to maintain a participant loan feature within an employee retirement plan, most 401(k) plans do allow these programs.  When choosing to allow a loan program within an employee retirement plan, it is important to adopt the loan policy features that are right for the plan. The loan policies can either be embedded within the plan document itself or reside outside the plan document. If a separate document exists, the plan document should refer to the separate loan policy. When offering loan programs, the plan’s sponsor must adhere to specific guidelines in accordance with regulations. It is important that the loan policies comply to these regulatory requirements. In addition, the administrative tasks related to participant loans can be daunting for plan administrators, and, therefore, it is important to choose the loan policies that are appropriate based on the size and structure of the plan. Following are a few helpful tips related to loan policies and related provisions.

Restrictions on Use of Loan Proceeds

While the regulations do not restrict the use of loan proceeds, plan administrators have the ability to put restrictions on the use of loan proceeds in order to reduce the number of loans withdrawn from participant accounts. For example, the loan policy can restrict the use of loan proceeds to only be used in cases of financial hardship, such as for medical expenses, education, purchase of a home or to prevent eviction from your home.

Restrictions on the Number of Loans Withdrawn

Many plan loan policies place restrictions on the number of loans a participant can have outstanding at one time to ease the burden of loan administration.  This assists administrators in following the requirements related to limits on the outstanding balance. Generally, participants are allowed to withdraw the lesser of $50,000 or 50% of their vested account balance. Limiting the number of loans outstanding also assists plan management in avoiding allocation errors of loan repayments that can occur when multiple loans are outstanding.

Loan Terms

Generally loans must be repaid within five years. The plan can stipulate longer repayment terms in their policies if the loan is for the purchase of a primary residence. Maintaining provisions for extended loan terms can be risky if the plan sponsor is in an industry with high turnover rates. Participants must be made aware of the tax implications of outstanding loans in the event they terminate employment with the plan sponsor (see loan repayment below regarding taxable transactions).

Interest Charged on Outstanding Loan Balances

Plan administrators are required to charge an interest rate that is reasonable. The method of determining the interest rate should be documented in the loan policies. Plan administrators should consider tying the interest rate charged to an indexed rate, such as prime rate, therefore eliminating the need for judgment when establishing the rate to be charged on the loan.

Loan Repayment

Most plan sponsors set up loan repayments as payroll deductions to ensure repayments are made in a timely manner in accordance with the repayment terms established. If the loan is not repaid in a timely manner (at least every 90 days under the regulations), the loan is considered in default and becomes a taxable transaction to the participant. In the event of termination of employment, it is common for loan policies to stipulate the repayment of outstanding loans within 60 days of termination to avoid considering the loan a distribution to the participant and therefore, a taxable transaction.

In summary, there are many options regarding the features of an employee retirement plan loan program. The plan sponsor and plan administrator should review the features available under their service provider’s contract and choose the policies related to the program that best suits the needs of the plan and the plan’s participants.

Continue the Conversation with Our Team
Get in touch with us.

Contact Us