Participant loans are a feature of many 401(k) Plans. Participants may borrow the lesser of $50,000 or 50% of the participant’s vested plan assets. Some 401(k) Plans allow a participant to have multiple loans outstanding at one time. In that scenario, the $50,000 limit is lowered by the highest outstanding loan balance during the one-year period ending on the day before the newest loan.
401(k) Plan loans have advantages, such as the fact that a participant can take out a loan for almost any reason. Additionally, most 401(k) Plan loans are repaid at an interest rate lower than many credit cards and the interest repaid is deposited back into the participant’s 401(k) balance – and not paid to the employer. Unfortunately, 401(k) Plan loan failures are common and can occur for many reasons. Three primary types of 401(k) Plan loan failures are: loans that exceed IRS prescribed limits; loan terms that exceed repayment limits; and loan defaults.
Thankfully, there are remedies to these failures. The IRS will forgive errors in these situations when Plan sponsors use the IRS’ Voluntary Correction Program (VCP). Correction of 401(k) Plan loan failures through the VCP helps preserve the 401(k) Plan’s tax-favored status. Correction methods through the VCP are as follows:
Loans Exceeding IRS Prescribed Limits
When a 401(k) Plan loan has exceeded the dollar limit mentioned above, the failure may be corrected under VCP if the participant repays the excess dollar amount to the Plan. If scheduled repayments were made before the error was discovered, those repayments may be applied on one of three ways:
- To reduce the interest on the loan excess so that the participant repays only the excess loan amount;
- To reduce the portion of the loan not exceeding the dollar limit so that the participant repays the excess loan amount (plus interest); or
- Pro rata against the loan excess and the maximum loan amount so that the corrective repayment equals the outstanding balance remaining on the original loan excess on the date the corrective repayment is made.
Loan Terms Exceeding Repayment Limits
This type of failure occurs when participants fail to satisfy the terms of the repayment schedule. Participants must repay 401(k) Plan loans within five years, unless the participant uses the loan to purchase a principal residence, and the participant must make loan repayments no less frequently than quarterly. When the repayment limits are violated, the IRS will treat the entire loan amount as a deemed distribution, including accrued interest. However, under the VCP, this failure may be corrected by reamortizing the loan balance over the remaining portion of the maximum repayment period.
When a participant defaults on a 401(k) Plan loan due to payments not being made as scheduled, this failure may be corrected under VCP in one of two ways. In the first scenario, the participant will make a lump sum payment in the amount of the missed payments plus accrued interest and then continue making loan repayments according to the payment schedule. Another option under VCP is for the participant to reamortize their outstanding 401(k) Plan loan balance, including accrued interest, over the remaining payment schedule of the original loan.
The IRS continues to simplify the VCP correction submission process in order to encourage Plan sponsors to voluntarily correct for Plan operational failures, such as 401(k) Plan loan failures.
If you have any questions, please contact Ken Kobiernicki or your ORBA advisor at 312.670.7444. Visit ORBA.com for more information about our Employee Benefit Plans Services Group.