Avoiding and correcting problems with plan loans.

• Author: Smith, Annette B.
• Position: Loans from qualified retirement plans

Participant loans from qualified retirement plans made on or after Jan. 1, 2002 must comply with final plan loan regulations under Sec. 72(p). These new regulations--which address issues such as repayment periods, suspension of repayments, and default and cure procedures--add to the complexity surrounding plan loans. This can lead to missteps, resulting in the loan amount being taxable to the participant, a prohibited transaction or a qualified plan operational failure.

Operational Failures

Under the qualification standards, a Sec. 401(k) plan may not distribute plan assets to a participant prior to a distributable event (e.g., death, termination, attainment of age 59 1/2 or hardship). Plan loans that adhere to the Sec. 72(p) limits and otherwise satisfy the standards for valid plan loans are not deemed distributions. Sec. 72(p) sets forth requirements as to the amount, term, repayment schedule and documentation of plan loans.

If it does not meet the Sec. 72(p) requirements, a plan may have made a prohibited distribution of its assets to a participant. Although such a distribution theoretically can result in plan disqualification, more likely the plan sponsor may be subject to penalties. Also, a prohibited distribution imposes a reporting obligation on the plan and subjects the participant to income inclusion to the extent of the prohibited distribution.

Another potential qualification failure--the alienation or assignment of benefits in violation of Sec. 401(a)(13)--might occur if the plan does not adhere to the requirements applicable to plan loans under Sec. 4975(d)(1), which provides an exception from the prohibited transaction rules. Again, such a violation could subject the plan to disqualification or the sponsor to penalties. Additionally, failure to follow Sec. 4975(d) may result in a prohibited transaction under Sec. 4975(c), which prohibits the direct or indirect lending of money between a plan and a disqualified person (such as an owner, officer or director). If a prohibited transaction occurs, an excise tax may be imposed on the plan sponsor.

Avoiding Plan Failures

Given the potential consequences of administrating plan loans improperly, plan sponsors need to understand how to avoid and correct failures.

Avoiding plan loan operational failures may be as simple as proactive plan drafting. Establishing comprehensive plan loan procedures and properly training administrative personnel on these procedures also reduces the potential...