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Tip of the Week: Tax Code and Regulatory Requirements Applicable to Loans

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.

Internal Revenue Code Section 72(p) establishes the requirements for loans from qualified plans. These rules apply to 403(b) plans and governmental 457(b) plans. Final regulations issued in July of 2000 also provide guidance on the proper defaulting and income tax reporting requirements for defaulted loans. Additionally, another set of final regulations were posted in the Federal Register on Dec. 4, 2002, dealing with miscellaneous issues such as refinancing of loans and new loans taken by a participant who has an outstanding defaulted loan balance.

The General Rules for 403(b) Plans

Under the Code and applicable regulations, the following is a summary of key issues affecting loans.

1. A participant may borrow (1) the greater of $10,000 or 50 percent of the vested account balance in all retirement plans of that employer, or (2) $50,000, whichever is less.

The $50,000 amount is reduced by the excess of the participant’s highest outstanding loan balance from the plan(s) during the 12-month period ending on the day before the date a new loan is made, over the outstanding loan balance on the date the new loan is made. This is where non-ERISA plans may differ from ERISA plans. Most ERISA plans limit loans to 50 percent of the vested account value because of the collateral requirements of ERISA. Since trustees and plan administrators are generally reluctant to hold outside collateral, ERISA loans are generally secured by the vested account balance. Loan limits apply to all plans of the employer. However, if an individual participates in plans with unrelated employers, separate loan limits would apply for each employer’s plan.

2. Loan repayments must be made at least quarterly with principal and interest amortized over a 5-year period, unless the loan is for the purchase of the participant’s principal residence. It is important to understand that the rule requiring at least quarterly repayments is a Code requirement. This means that a participant may not adopt any payment schedule that is less frequent than quarterly. A number of providers do permit monthly repayment schedules. There is no Code violation if the required payments are more frequent than quarterly.

3. For loans made to purchase a principal residence, the repayment period may be extended. While the Code does not clearly define the extension, most providers allow the payback to coincide with the term of the  mortgage. In the final regulations, the IRS uses a 15-year repayment term in one of its examples. However, this doesn’t settle the issue of determining an acceptable period. It simply provides reassurance that loan payback periods of at least fifteen years are acceptable. In recent audits the IRS has accepted loans over a 30-year period, so having the period coincide with the mortgage terms seems to be acceptable.

4. Loans may be made for any reason, (i.e., there is no qualifying event for eligibility to borrow). However, some plans or products impose restrictions.

5. The entire outstanding loan balance must be defaulted if a quarterly payment is not made by the end of the default period. Under the regulations, the default period cannot extend beyond the last day of the quarter following the quarter in which the payment was due. However, a plan document, custodial account or annuity contract may have a shorter default period.

6. Unless a participant has experienced a distributable event, a defaulted loan is considered to be a “deemed distribution” for tax reporting purposes. This means that the entire loan balance is immediately taxable and may be subject to the premature distribution penalty of 10% under Code Section 72(t). A deemed distribution can occur even if there is no distributable event. The final regulations require that a loan that has been defaulted as a deemed distribution must continue to be held on the records of the provider until such time as the affected participant is actually eligible for a distribution such as age 59½ or separated from service. Any repayments made after a loan has been defaulted are treated as after-tax contributions for the purposes of future income tax reporting and basis recovery, but not for the purposes of the contribution limits. Although interest does not continue to accrue for reporting or tax purposes after a default, the final regulations require the inclusion of “deemed” interest solely for purposes of eligibility for future loans; determination of payoff figure for the defaulted loan; and if the Plan is subject to ERISA, reporting it in the Form 5500. Such amount is counted against the $50,000 maximum loan limit.

7. An outstanding loan that was previously defaulted as a deemed distribution will prevent the participant from taking out a new loan unless the sponsoring employer permits payroll deducted payments on the new loan or unless the plan (or in the case of non-ERISA loans, the provider) will permit outside collateral. Generally, many employers do not permit 403(b) or 457(b) plan loan payments via payroll deductions and most plans and providers refuse to hold outside collateral. Therefore, a defaulted outstanding loan balance will generally prevent a participant from making another loan from any plan of the employer until the outstanding defaulted loan has either been repaid, or distributed when the participant is eligible for a distribution. It is also not uncommon for plan language (or the annuity contract or custodial account, if vendors have separate loan policies) to prohibit the taking of a new loan if the participant has an outstanding defaulted loan.

8. The 2002 final regulations established new requirements for refinancing loans. A refinanced loan is defined as a new loan that replaces a current loan. A refinanced loan, if it offers a term longer than the original loan, must be added to the outstanding balance of the “old” loan to determine whether the participant is eligible for the new loan. However, if the loan payments are designed to pay off the outstanding amount of the old loan in the same term as it otherwise would have been paid off with only the difference attributed to the new loan permitted to have a new term, the two balances do not have to be added together to determine eligibility for the new (refinanced) loan. This new rule will make it difficult to monitor the refinancing of old loans. It also may present systems challenges for providers that offer loans. Providers that permit multiple loans to be taken generally do not permit refinanced loans.

9. An individual on unpaid leave of absence (other than qualified military leave) can discontinue payments for up to one year on the outstanding loan or until they return to work, whichever occurs first. The term of the loan, however, cannot be extended. This would mean the payments would have to increase upon the individual’s return to ensure that the loan is paid by the end of the original term. If the borrower is receiving salary during the leave (such as a sabbatical leave) sufficient to make loan payments, then payments must be continued during the leave.

10. An individual on military leave is permitted to cease payments on the loan. After the military service has ended, the individual can resume payments and extend the term of the loan by the length of the military service. Additionally, the maximum interest rate that can be charged for the loan during the military leave is 6%.

11. There are no specific minimum loan requirements for non-ERISA loans. In an ERISA plan, the loans must be available on a nondiscriminatory basis. Thus, the minimum loan requirement in a 403(b) ERISA plan can be no greater than $1,000.