Editor’s Note: This is an occasional feature in the NTSA Advisor. It is drawn from The Source, a book that covers technical, compliance, administrative and marketing aspects of the 403(b) and 457(b) markets. More information about The Source is available here.
Each product provider that offers a loan provision under an annuity contract or custodial account will establish its own rules governing loans from accounts held under the contract or custodial account. Participants should consider “shopping” among providers if loans are an important consideration. Below are some common variations to consider.
Interest rate charged on the loan. Most annuities charge a “prevailing” interest rate such as the prime rate or Moody’s, then credit a lesser interest rate to the contract holder’s account. The variance will be the net cost in terms of the actual interest of the loan itself. Many will charge a net 2%. There are some loan provisions charging as much as 4% net. During a webinar that the IRS held discussing loan requirements, it was mentioned that the interest rate must be reasonable, and if the vendor, employer or TPA was not using the “average” interest rate (obtaining a rate from a few national banks, lending institutions, etc., and then taking an average of those rates), then IRS views “reasonable” as meaning the Prime rate plus 2%. This was verbal only but has prompted many to change their interest rate from Prime, or Prime plus 1% to Prime plus 2%. There has been no update or mention of the term since the webinar.
Timing of loan availability. Many loan provisions allow immediate loans; others have a waiting period varying from 30 days to one year. If an individual is transferring a 403(b) value from one vendor to another specifically to use the loan provision, then immediate access to the loan may be important.
Amount of account available for loan. Check whether the provider will allow the full limit of the “greater of $10,000 or 50 percent of value” allowed under the Code. Some will limit loans to a straight 50 percent of value. Others may allow limited borrowing such as limiting loans to accounts that have minimum levels such as $10,000.
Loan procedures. Remember that it is important for the participant to receive notices of payments due or past due in order to avoid defaults through oversight. Check to be sure that the product provider has such procedures in place.
Multiple loans. Some providers will not allow more than one outstanding loan. Be sure to check the specific loan design of the providers. Also, employers may have additional restrictions or rules relating to loans under their 403(b) program, usually seen in ERISA 403(b) plans. It is important to understand and differentiate the rules as specified in the Code, the rules specific to the 403(b) product provider and possibly rules set out by the employer.
Caution. In audits of 403(b) plans, the IRS is focusing on loan defects. Care should be taken to ensure that loans are coordinated among all providers for all of the employer’s plans, including State retirement systems that offer loans.