If the plan document permits loans, it is important that a formal loan program be adopted. Certain restrictions on loans must be reflected in the loan program. Administration of loans to participants consistent with governmental regulations is essential.
Loans limited to 50% of the vested account balance, but not more than $50,000, may be granted to participants. Administration of plan loans can be divided into two categories: new loans and existing loans.
1. New loans
Plan loans must satisfy numerous requirements; some are described below.
It is important that certain legal specifications be met to avoid the loan's being treated as a prohibited transaction. These requirements include that the loan be adequately secured, available to all participants on a reasonably equivalent basis (and not made more available in a greater amount to "Highly Compensated Employees") and consistent with the terms of the loan program. The loan must also bear a reasonable rate of interest.
Other requirements must be satisfied for the loan to avoid being classified as a deemed distribution. The loan must not exceed a maximum amount and it must be repaid within five years, in level installments, payable at least four times a year. A longer repayment period is available if the loan is used for a principal residence.
Employers must ensure that the proper documents were completed for any loans issued during the year. These include a note and security for the loan and, if applicable, spousal consent. In addition, loans may not be granted in excess of the number permitted by the plan's loan policy.
2. Existing loans
Whether the loan is being repaid through payroll deductions or other means, the amount and date of the loan payments must be confirmed. The entire loan may be taxable if it is not properly repaid. Defaults in plan loans can create serious difficulties for both the employer and employee.