I didn’t know a participant could take a loan from their 401(k) Plan. Is it legal and how is it administered?
What’s unique about the Guidant master plan document is the ability to take a participant loan. It’s important to note that your 401(k) Plan Document must have or be amended to reflect the participant loan feature. Please read and confirm acknowledgement of the participant loan Frequently Asked Questions (FAQs).
What is a participant loan?
A participant loan is when an eligible employee of a plan removes money from their 401(k) account, with a promise to pay it back with interest, within a specified time period.
Why are loans allowed?
Normally a loan between a participant and the plan would be a prohibited transaction; however the IRS has created an exemption to this rule, as long as certain circumstances are met.
- Loans must be made available on a reasonably equivalent basis. For example loans cannot be allowed for key employees and not allowed for non-key employees.
- Loans must be nondiscriminatory in amount.
- The loan must be documented with loan documentation and the Adoption Agreement must allow for loans.
- A reasonable rate of interest must be charged.
- Adequate security for the loan is required. The security is in the form of the vested balance in the plan.
What is considered a reasonable rate of interest?
A loan must charge a rate of interest similar to what other companies in the business of lending money are charging for loans. The IRS has unofficially stated that prime plus 2% can be considered a safe harbor interest rate.
Who can take a loan?
Any employee that has met the eligibility requirements of the plan and has a sufficient balance in their 401(k) account may take a loan.
Is there a limit on the amount that can be taken as a loan?
The IRS has set a limit of 50% of the vested account balance or $50,000, whichever is less.
Are the limits changed if I already have an outstanding loan?
Yes. We’d take into account the outstanding loan balance when calculating the maximum loan available.
How long do I have to pay back the loan?
The maximum repayment period for a standard participant loan is 5 years, unless the loan is for the purchase of a primary residence.
What happens if I do not make a payment on my loan?
The IRS has a set requirement that payments must be made at least quarterly to avoid going into default. Thus, they have a set “cure period” for making payments and any loans that have payments not made within this “cure period” are considered to be in default. If a loan is considered to be in default, a deemed distribution will occur. A deemed distribution requires that a 1099-R be issued (with a code L) for the amount of the outstanding loan balance. The participant will owe taxes on this amount when filing their personal taxes. The deemed distribution does not alleviate their obligation and the participant will be expected to resume making payments.
What is the “cure period”?
The cure period is the grace period that a participant has to make their loan payments. Loan payments must be made no later than the last day of the quarter following the quarter in which the payment was due.
What are the defaults for loans?
- The minimum loan amount will be $1,000.
- The maximum number of loans allowed at one time will be two.
- Loans will be repaid via check, ACH, or payroll deduction.
- The loan interest rate will be Prime + 2%.
If I have rolled money into the plan but not met the eligibility requirements, can I take a loan?
No, you must meet eligibility requirements to take a loan.
If a new plan would like to allow for loans, or if a plan would like to amend to allow loans, immediate eligibility must be chosen so that the participants will not violate this rule by taking loans out too early.