2003 Lane Reports

Borrowing from Your Retirement Plan Account

Tuesday, April 1, 2003
by Joshua S. Kreitzer, J.D.

If you participate in a qualified retirement plan, and you're in need of a loan, you may be interested in borrowing money from your plan account. And the law now allows all business owners to borrow from their retirement plans and take advantage of an economic opportunity which in some cases had only been available to rank-and-file employees.

If the rules of your plan permit such a loan, you may find that borrowing from your plan account is one of the most advantageous ways to get a loan C but there are Federal laws and regulations that you'll have to follow.

Under Internal Revenue Code ("IRC") Section 72(p) and the regulations thereunder, a loan to a participant from a qualified employer retirement plan is a deemed distribution to the participant (and thus considered taxable income) unless the loan satisfies the requirements listed below:

1. The loan must be evidenced by a legally enforceable agreement (which may consist of more than one document) which specifies the amount and date of the loan and the repayment schedule. The agreement must be set forth in a written paper document, in an electronic medium which satisfies the requirements of the regulations, or in such other form as may be approved by the IRS.

2. The loan, by its terms, must be required to be repaid within no more than 5 years, unless the loan is used to acquire a dwelling unit which is to be used as the participant's principal residence.

3. "Substantially level amortization" is required over the term of the loan. This means that required payments of principal and interest must be substantially equal over the term of the loan. Furthermore, payments must be required at least quarterly.

4. A loan will not satisfy these requirements unless the loan, when added to the outstanding balance of all other loans from the plan to the participant, does not exceed the lesser of C

(a) $50,000, reduced by the excess (if any) of (i) the highest outstanding balance of loans from the plan during the one-year period ending on the day before the date on which such loan is made, over (ii) the outstanding balance of loans from the plan on the date on which such loan, or

(b) the greater of (i) one-half of the present value of the nonforfeitable accrued benefit of the employee under the plan, or (ii) $10,000.

While the loan amount limitation formula appears complex, the easiest way to think about it is to remember that a participant will not be in compliance with these regulations if the participant has a loan balance in excess of $50,000, regardless of the participant's total vested balance in the plan; furthermore, in some cases, the participant will not even be allowed to borrow the full $50,000.

For purposes of the amount limitations, all plans of the same employer or related employers are treated as one plan.

Example: Bob is a participant in both a profit sharing plan and a money purchase pension plan which are sponsored by the same employer. Bob has a vested balance in the profit sharing plan of $75,000 and a vested balance in the money purchase pension plan of $50,000. Bob currently has no outstanding loans from these plans, nor has he had any such loans in the last year. For purposes of the loan rules, Bob has a total of $125,000 of nonforfeitable accrued benefits under the plans. Thus, Bob can borrow up to a total of $50,000 from either plan or from the two plans combined. He may not treat the plans separately and borrow $37,500 from the profit sharing plan and $25,000 from the money purchase pension plan.

A participant may have more than one loan outstanding from a plan as long as all loans meet the criteria discussed above.

Example: Cheryl's total vested account balance in a qualified retirement plan exceeds $100,000. On January 15, 2004, Cheryl borrows $40,000 from the plan. She makes monthly payments on the loan, which must be repaid in full within five years, and, by December 1, 2004, her balance has been reduced to $33,000. Cheryl decides to request another loan from her plan, for the maximum amount which she is now eligible to borrow.

Using the loan amount limitation formula, the highest outstanding balance she had during the previous year was $40,000 (the initial balance before she made any payments) and the outstanding balance on the day before the new loan is made is $33,000. The excess of $40,000 over $33,000 is $7,000. $50,000 reduced by $7,000 is $43,000. This means that the total balance of both the new loan and the existing loan may not exceed $43,000. Since Cheryl already has a balance of $33,000 on one loan, she may now borrow an additional $10,000 from the plan. Cheryl must continue to repay the original loan according to the original loan repayment schedule as well as repaying the new loan according to its repayment schedule.

In addition to the requirements imposed under the IRC, the Employee Retirement Income Security Act of 1974 ("ERISA") also imposes requirements on plan loans. Under regulations established by the Department of Labor, plan trustees need to make sure that participant loans (1) are available to all participants on a reasonably equivalent basis; (2) are not made available to highly compensated employees, officers, or shareholders in an amount greater than the amount made available to other employees; (3) are made in accordance with specific provisions regarding such loans set forth in the plan; (4) bear a reasonable rate of interest; and (5) are adequately secured.

The requirement that loans be available to all participants on a reasonably equivalent basis means that loans must be available to participants without discrimination on the basis of such factors as age, sex, race, or national origin. The plan may only consider such factors as would be considered in a normal commercial setting by an entity in the business of making loans, such as the participant's creditworthiness and financial need.

Furthermore, plan loans may not be made available to highly compensated employees, officers, or shareholders in an amount greater than the amount made available to other employees. This rule would prohibit a plan from, for example, imposing a minimum loan of $40,000, if many participants in the plan would thus be shut out from borrowing for failure to have at least $80,000 in vested benefits.

Also, there must be specific provisions set forth in the plan, or in a written document forming part of the plan, which authorize the loan program, identify who is authorized to administer the loan program, and describe the procedure for applying for loans, the basis on which loans will be approved or denied, the procedure for determining a reasonable rate of interest, the types of collateral which may be used to secure the participant loan, and the events constituting default and the steps which will be taken in the event of default.

The requirement that a participant loan bear a reasonable rate of interest means that the loan must provide the plan with a return commensurate with the interest rates which would be charged under similar circumstances by persons in the business of lending money. However, the Department of Labor has declined to establish a minimum or "safe harbor" interest rate for plans to use.

Finally, the loan must be adequately secured. Typically, this means that a participant must enter into a security agreement whereby up to one-half of the participant's vested plan balance is used as security for the loan.

The Economic Growth and Tax Relief Reconciliation Act of 2001 made a beneficial change which expanded the availability of loans to retirement plan participants. Under prior law, sole proprietors, partners who owned more than 10% of the capital or profits interests in a partnership, and employees of S corporations who owned more than 5% of the S corporation's stock were not allowed to borrow from their businesses' retirement plans (even though their rank and file employees could do so). Since January 1, 2002, however, sole proprietors, partners, and S corporation owners are allowed to borrow from their businesses' retirement plans on the same basis as their employees. This brings their eligibility for plan loans into line with the stockholder-employees of C corporations, who were, and continue to be, eligible to borrow from their businesses' retirement plans.

If you own a business which operates a retirement plan, and you'd like to establish a participant loan program, please let us know; we'll be glad to advise you.


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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

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