A loan at last?

Adding a loan feature to your 401 (k) can perk up participation in a hurry, but you need to know your way around ERISA and how to minimize the extra administrative costs.

In only five more years, some 3.5 million workers will participate in approximately 310,000 401 (k) plans with total assets of $1 trillion. To encourage employees to participate as much as possible, many companies adopt loan provisions, which allow participants to borrow part of their retirement money without incurring an early-withdrawal penalty. But it's estimated that only about 65 percent of all 401 (k) plans have loan provisions.

The reasons are simple. While loans help you attract more participants, they also add to your plan administrators' workloads and responsibilities and, ultimately, to your administration costs. What's more, they contain potential tax traps, and your administrators are also responsible for helping employees avoid those pitfalls. So if you're thinking of adding a loan provision, you should carefully review the responsibilities that your administrators or an outside firm would assume.

First, make sure you thoroughly understand the complex set of rules governing the administration and granting of 401 (k) loans. Loans are permitted only if the plan language specifically authorizes them, although you don't have to put in a loan provision when you first adopt a 401 (k) - you can add it later on. Sole proprietors, business partners with a greater than 10-percent share and S-corporation shareholders with a greater than 5-percent share generally aren't eligible for loans, unless you get a specific Department of Labor exemption. But the loan provision is open to all other participants.

Loans of more than $3,500 are subject to federal written spousal-consent rules. If a married 401 (k) participant applies for a loan, you must inform the spouse of the loan in writing, and the spouse must give his or her written consent within 30 days after receiving the notice.

You also need a formal loan policy that will identify the person or persons responsible for administering the loans, describe the loan-application procedure, set out the basis on which you'll approve or deny the loans, specify the amount and type of loans you'll permit, describe the process of determining interest rates, identify the collateral necessary to secure the loans and spell out default procedures.

THE LOAN RANGER 

Be careful about setting interest rates. By regulation, interest rates for 401 (k) loans must match prevailing rates at banks or other lending institutions in the market for the same loan with similar security. In most plans, the borrowers actually pay the interest back into their own accounts. Therefore, if the interest is above competitive rates, the Internal Revenue Service may declare the loan is actually a scheme to make additional contributions to the account. If it's below the prevailing rates, the loan might be considered a disguised early distribution and could then be subject to the penalties for an early withdrawal.

By law, the upper limit on a 401(k) loan is 50 percent of an employee's vested interest in the plan or $50,000, whichever is less. Participants can apply for additional loans even if they have outstanding 401(k) loans, as long as the combined outstanding balances have remained below the 50 percent/$50,000 limit for the 12 months before each new loan. You must apply the highest outstanding loan balance the participant had within the prior 12 months against the $50,000 limit.

If a participant wants a loan exceeding 50 percent, you can grant the request if the participant can provide sufficient additional collateral. However, $50,000 is still the top limit for the loan. Your plan administrator is responsible for determining whether the participant has enough collateral. Most plans don't allow these types of loans, because in the event of default, the loan administrator would have to foreclose on the collateral. If the collateral then turns out to be insufficient, the administrator could be considered in breach of his or her fiduciary duties.

Typically, participants have five years to repay the loan, and they cannot renegotiate the loan to extend the repayment limit. However, if the loan is for a down payment on a principal residence, the borrower may take longer, typically about 10 years. Of course, that also means you'll have to service the loan for a longer period of time.

If you decide to offer 401 (k) loans, you can take certain steps to reduce the administrative burden. For example, you can establish a minimum loan of $1,000, which allows participants access to funds for many purposes but eliminates the problem of participants applying for smaller spur-of-the-moment loans, which require the same administrative attention as larger ones.

Another option is to limit loans to major needs, such as paying medical costs, funding college tuition or purchasing a home. Remember that if the 401 (k) plan has a hardship provision permitting withdrawals, the participant would have to take a loan first before he or she could use the withdrawal provision. That's because hardship provisions are set up to be used only after the participant has exhausted all other financial avenues, and a loan is considered a financial resource.

The more loans your participants take, the higher your administrative costs will be. To offset this burden, some administration firms recommend you charge your employees a fee for loan processing. These fees are typically only about $50 per loan, but that adds up if you're servicing many loans. You can also charge participants a $25 annual loan-administration fee. Both of these fees can be added to the loan amount, or you can have the borrower simply write a check for the fees.

Employees' principal and interest payments must be amortized at least quarterly. If borrowers make their payments directly, the administrator is responsible for ensuring they meet the loan's quarterly amortization schedule. If they fail to make a payment, the IRS will treat the outstanding balance as an early distribution subject to taxes and an early-withdrawal penalty, and you must inform the borrowers of that. However, they're still obligated to repay their loans, and you're still required to service them.

To avoid this extra administrative layer, you can require employees to make their loan payments through payroll deductions. This is the simplest way to administer loans, because the administrator gives the payroll department the schedule for withholding funds from each paycheck.

KEEP IT ROLLING

It's a good idea to keep reminding employees, through your employee-benefits communications, that the tax consequences of leaving the company with an outstanding loan and a distribution can be unpleasant. For example, suppose an employee at a large manufacturing company borrows $10,000 from his $20,000 account. A year later, he leaves the company and opts for a distribution of his 401 (k) account. The value of the account is now $22,500, including an $8,500 loan balance and $14,000 of other assets. He'll receive $14,000 in cash, but his 1099R form will show a distribution of $22,500. He can't roll the loan into an individual retirement account, so the $8,500 is considered taxable.

In addition, if he doesn't roll over the balance, he won't have much left after the tax man gets through with him. Assuming the employee is under age 59-1/2 and in a 28-percent tax bracket, he'll have to pay a $2,250 penalty and $6,300 in taxes, for a total of $8,550, leaving him $5,450 net (the $14,000 balance minus $8,550).

If an employee does leave your company with an outstanding loan and wants to roll over the remaining funds into an IRA, you'll have to issue a form 1099 for the total value of the account but forward only the funds equal to the account balance, minus the outstanding loan.

On the other hand, if you terminate your 401 (k) plan for any reason, your plan administrators must issue checks to all borrowers for the actual funds in their account and 1099 forms for the total value of the account, including the amount of the unpaid loans. In this case, however, the borrowers don't have to repay the loans.

Adding a loan feature to your 401 (k) can be a great way to encourage employees to participate. That's especially true for those who fear investing in a retirement plan means not having any access to their money if they need it before retirement. Just make sure you know the 401(k) rules forward and backward and that you've thoroughly analyzed what your additional administrative expenses are likely to be. Once you do that, get ready for a new wave of enthusiasm for your 401 (k).

Mr. Maloney is president of AVM Financial Services in Schaumburg, Ill.