Last week I read two interesting articles about 401(k) plan participant loans. One article suggested that in a struggling economy, plan participants were better off borrowing from themselves through a plan loan. Another article reported that 80% of terminated employees who had outstanding loans from their previous employer's 401(k) plan defaulted on those loans. It also reported that nearly 20% of 401(k) plan participants maintained an outstanding loan. For plan sponsors, this can create a real problem because dealing with plan loans is not always as simple as it sounds.
IRC Code §72 generally sets out restrictions on plan loans but it does not restrict the number of loans a plan participant can take. §72(p)(2) provides that a loan to a plan participant will not be treated as a distribution to the participant as long as the loan is limited in accordance with the terms of the Code. If a loan does not satisfy the Code’s requirements, then the loan is deemed to be a taxable distribution to the participant. This can happen if the participant does not make the payments required under the terms of the loan. Because the plan sponsor (usually the employer) has and obligation to properly report and treat loans as taxable or non-taxable based on these rules, administering outstanding loans can be a problem hidden away waiting to jump out at you if you are ever audited.
The IRS has a couple of useful "Fix-it" statements relating to 401(k) loans. One discusses how to treat defaults in payment. The second addresses non-conforming loans. Both look at how to fix the problems, which means they are problems that have to be fixed by the sponsor. They also suggest some possible ways to avoid mistakes in loan administration, like permitting cure periods for missed payments, requiring transmittal of loan information to payroll before loans are permitted, reviewing plan documents regarding loan requirements and actually creating a written loan policies that should be followed every time a loan is requested.
On top of that, consider a couple other suggestions. Maybe your plan should only permit one loan at a time or there should be a limit on the size and scope of the loans. You should also consider your procedures for monitoring and collecting loans from participants after they have terminated employment and establish a procedure for keeping track of whether those loans have been satisfied. Since non-conforming loans are clearly a component of the IRS's audit package for 401(k) plans, it pays to know more about loans, better manage them and accurately report them before you face an audit. So don't simply assume plan loans are being handled properly. Look into them now and fix your mistakes. If you need assistance, your attorney at Fox Rothschild can help you sort it out..