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A primer: loans from retirement plans.

In order to encourage employees to save for retirement, substantial tax breaks are offered to employees who participate in their employers' qualified retirement plans. For example, retirement plans with cash or deferred arrangements allow participants to defer a portion of their salary until retirement; both the salary deferred and the earnings on the deferrals are not subject to income tax until distributions are made. Profit-sharing and money purchase pension plans provide employers with an opportunity to make tax-deductible contributions to their employees' accounts. Because the intent is for plan participants to leave the funds in their retirement plan accounts until retirement age, there are stringent requirements for those who wish to withdraw funds before retirement without paying substantial penalties,

One method for making funds available to plan participants before retirement is through loans. Whether or not to make loans available to participants is a difficult decision. The employer must take into account the expense incurred in administering retirement plan loans, and the problems that may result if a participant defaults. On the other hand, the availability of a loan program may persuade an employee who is concerned about tying up funds until retirement to participate in the plan. Most individuals realize they must begin saving for their own retirement as soon as possible; however, the notion of putting aside money today that cannot be withdrawn until retirement, termination of employment or death may not be acceptable. It is for this reason that employers may be willing to incur the additional time and expense associated with administering a retirement plan with a loan program.

The Department of Labor (DOL) has issued guidelines under the Employee Retirement Income Security Act of 1974 (ERISA) that prohibit a plan from lending money to participants unless specific criteria are met. The IRS paralleled the DOL loan restrictions which, if not met, will cause the loan to be classified as a prohibited transaction subject to a 5% excise tax (Sec. 4975). In addition, a loan may be treated as a distribution subject to income tax and a 10% excise tax under Sec. 72(t), if it fails to meet restrictions under Sec. 72(p) as to the amount of the loan.

For loans made after 1988, the loan program must be contained in the retirement plan document or written document that is incorporated by reference as part of the plan. It must include at least seven items, including the identity of the person authorized to administer the loan, the loan application procedure, the criteria for approving or denying loan requests, the limitations on the types and amounts of loans offered, the procedure for determining a reasonable rate of interest, the type of collateral securing the loan, and events constituting default and the steps that will be taken on default. For loans made before Jan. 1, 1989, a plan simply had to authorize plan fiduciary to establish a participant loan program. Considering the number of employers who in recent years have adopted master or prototype plans, it is very important to ensure that these employers have a written loan document. Although these plans usually provide for a loan program, they very seldom include the language needed to establish the loan program within the plan itself, rather than referring to an outside document.

Under ERISA, a participant loan program must be prudently established and administered for the exclusive purpose of providing benefits to plan participants and beneficiaries. Loan must be made available to all participants and beneficiaries on a reasonably equivalent basis. The factors that may be taken into account are limited to those that would be considered in a normal commercial loan setting, such as the applicant's creditworthiness and financial need; factors such as the individual's race, color, religion, sex, age or national origin may not be considered. The loan program may set a minimum loan amount of up to $1,000, but may not permit loans to be made available to highly compensated employees in amounts greater than the amounts available to other employees. The loan program will not fail simply because the maximum loan amount will vary directly with the size of the participant's accrued benefits. The loan must bear a reasonable rate of interest that is similar to the interest rates charged by other lenders. Under Sec. 72(p), loans must be repaid within five years under a substantially level amortization schedule, with payments at least quarterly. Payments may be delayed for up to one year for participants on compensated leaves of absence.

ERISA and Sec. 72(p) provide that loans must be adequately secured. Under ERISA, no more than 50% of the present value of a participant's vested accrued benefits may be considered by the plan as security for the loan. Sec. 72(p) provides an additional limitation under which the total balance of all of the participant's outstanding loans from the plan may not exceed the lesser of $50,000 or onehalf of the present value of the participant's nonforfeitable accrued benefit. However, if the accrued vested benefit is under $20,000, the plan may allow for a loan of up to $10,000. When determining the outstanding balance of all plan loans to a participant, amounts outstanding within the past year must be aggregated with the current loan. This prevents an employee from receiving, for example, a $50,000 loan, paying it off, and the next day borrowing an additional $50,000.

If a loan is secured by a mortgage on the borrower's primary residence, special rules apply. For instance, the loan term is not limited to five years if the loan proceeds are used purchase the home. However, except as explained below, the amount of the mortgage loan is still subject to Sec. 72(p). Since home mortgages are frequently greater than $50,000, these limitations can create quite a problem.

In some circumstances, mortgage loans may escape the Sec. 72(p) limitations. According to the committee reports accompanying the Tax Equity and Fiscal Responsibility Act of 1982, if the plan trustee determines that residential loans will be made by the plan as part of an investment program, the residential loan will not be subject to the restrictions of Sec. 72(p,) provided the amount of a loan does not exceed the fair market value of the property purchased with the loan proceeds. An investment program may exist, for example, when the trustees specify that a fixed amount or a percentage of the plan assets will be invested in residential mortgage loans. These loans may not be made available to officers, directors or owners or their beneficiaries.

A serious limitation on plans establishing a mortgage investment program is that it may not be established primarily for plan participants. According to the IRS, a plan may establish an investment program to invest in residential mortgages, including, but not limited to, mortgages of plan participants; however, if the majority of the loans made are to the participants in the plan, the Service will likely take the position that the loan program is simply trying to avoid the limitations of Sec. 72(p) (IRS Letter Rulings 8824045 and 9110039).

It is often necessary to have a loan option in a qualified retirement plan to encourage more employees to participate in the plan. The employer must determine whether the benefits of a loan program outweigh the extensive restrictions with which plans must comply and the related administrative costs. Plans that establish an investment program in residential mortgage loans as part of their overall investment policy can provide plan participants with a significant benefit by avoiding application of the of the Sec. 72 limitations. Care must be exercised, however, to ensure that the investment program is not established primarily for the benefit of participants; this may be accomplished, for example, by providing a substantial number of residential loans to qualifying individuals not currently benefiting under the plan.
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Author:Gula, Kristin M.
Publication:The Tax Adviser
Date:Dec 1, 1992
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