A primer: loans from retirement plans.

• Author: Price, Gene A.

In order to encourage employees to save for retirement, substantial tax breaks are offered to employees who participate in their employers' qualified retirement plans. For example, retirement plans with cash or deferred arrangements allow participants to defer a portion of their salary until retirement; both the salary deferred and the earnings on the deferrals are not subject to income tax until distributions are made. Profit-sharing and money purchase pension plans provide employers with an opportunity to make tax-deductible contributions to their employees' accounts. Because the intent is for plan participants to leave the funds in their retirement plan accounts until retirement age, there are stringent requirements for those who wish to withdraw funds before retirement without paying substantial penalties,

One method for making funds available to plan participants before retirement is through loans. Whether or not to make loans available to participants is a difficult decision. The employer must take into account the expense incurred in administering retirement plan loans, and the problems that may result if a participant defaults. On the other hand, the availability of a loan program may persuade an employee who is concerned about tying up funds until retirement to participate in the plan. Most individuals realize they must begin saving for their own retirement as soon as possible; however, the notion of putting aside money today that cannot be withdrawn until retirement, termination of employment or death may not be acceptable. It is for this reason that employers may be willing to incur the additional time and expense associated with administering a retirement plan with a loan program.

The Department of Labor (DOL) has issued guidelines under the Employee Retirement Income Security Act of 1974 (ERISA) that prohibit a plan from lending money to participants unless specific criteria are met. The IRS paralleled the DOL loan restrictions which, if not met, will cause the loan to be classified as a prohibited transaction subject to a 5% excise tax (Sec. 4975). In addition, a loan may be treated as a distribution subject to income tax and a 10% excise tax under Sec. 72(t), if it fails to meet restrictions under Sec. 72(p) as to the amount of the loan.

For loans made after 1988, the loan program must be contained in the retirement plan document or written document that is incorporated by reference as part of the plan. It must include at...