Interest Rates Must Be More Than Interesting
Plan loans are governed by many IRS and Department of Labor (DOL) rules and regulations. Even though they are an optional plan feature, if you choose to offer plan loans to your participants, your plan document must comply with the current laws, including the interest rate charged on these loans. Some plan documents stipulate an interest rate, while others do not.
Neither the IRS nor DOL provides a set percentage for plan sponsors to use; however, both require the rate to be reasonable. The IRS asks if the interest rate is similar to local interest rates and to what local banks charge individuals for similar loans with similar credit and collateral. DOL regulations provide that an interest rate is reasonable if it is equal to commercial lending interest rates under similar circumstances.
The DOL provides several examples of how to determine the interest rate. For example, suppose the plan loan interest rate is set at 8%, but local banks offer between 10% and 12% for similar circumstances. In this example, the loan will fail to meet the reasonable standard.
Unreasonable Rate Consequences
If your plan fails to assess a reasonable interest rate, participant loans may result in a prohibited transaction. What does this mean? Prohibited transactions are certain transactions between a retirement plan and a disqualified person. Disqualified persons taking part in a prohibited transaction must pay a tax.
A prohibited transaction includes the lending of money or other extension of credit between a plan and a disqualified person. However, the laws specifically exempt plan loans from the prohibited transaction list. If your interest rate is not reasonable, the plan loan may lose its exempt status and become subject to the prohibited transaction tax.
Time for Review
Review your plan document and loan policy statement to determine if the plan sets an interest rate. Make sure your plan loan interest rate is reasonable and consider updating the document to comply with the regulations and interest rates if necessary.
If you have questions about the interest rates you are charging for plan loans, please contact Jim Quaid or call him at 312.670.7444.