Chapter 5...
Loans
Advantages and Disadvantages of 401k Loans
Terminating Employment When There's An Outstanding Loan
Processing Loan Applications
-- Entering Approved Loans Into the System
-- Entering Loans and Repayments Into Your Payroll Software
-- Entering Monthly Loan Repayments Into the System
-- Interfacing with the Investment Account Company
-- Current Loans List
Advantages and Disadvantages of 401k Loans
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Table 5-1. Advantages and Disadvantages of 401k Loans |
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Advantages |
Disadvantages |
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Plan participants can borrow up to 50% of vested account balance, up to a maximum of $50,000. Interest paid on the loan goes back into the participant's account. Repayment (interest and principal) are automatically deducted by Payroll. The participant has up to five years to repay the loan, 10 years if the loan is for purchase of a primary residence. Participants can access money that otherwise would not be available until retirement. A 401k loan interest rate is probably lower than the participant could get elsewhere. |
The participant "borrows" his/her own money: It's not really borrowing but taking out of savings. Money loaned out isn't earning any investment returns; "interest" paid by the participant on the loaned money is merely a way of trying to compensate for what would have been earned. In cases of a default, the loan amount outstanding is considered a premature 401k distribution on which the person will owe income tax plus a 10% penalty if the person is younger than 59 1/2. Repayments (principal and interest) are made with after-tax dollars -- and when the participant withdraws the repaid money after retirement, he/she will pay tax on it a second time. If the loan is used to buy a primary residence, the interest paid is NOT tax deductible, which it would be for a conventional home loan. If the borrower leaves the company before the loan is repaid, he/she must pay the balance due or the unpaid balance will be treated as an early distribution and subjected to the penalties and taxes of such. |
Because of the considerable financial implications for the borrower, your 401k's standard materials limit loans to serious needs — using the same criteria as for hardship withdrawals. We recommend that your company maintain such a stringent loan policy. Often the borrower leaves the company before the 401k loan is paid in full, and must come up with the cash to pay off the loan or treat the unpaid balance as an early distribution (see “Terminating Employment When There's an Outstanding Loan,” below). Thus the borrower can be faced with a financial difficulty or a tax problem at a time when he or she is either unemployed or starting a new job.
Loan policies are set by your company. The loan application in the 401k Loan Pac gives guidelines, but these are not programmed into your plan administration software. If your plan allows loans, your company must have a separate written document describing the specifics of your loan program and must designate a Loan Administrator, who may or may not be the same person as you, the Plan Administrator. Here, we assume that the Plan Administrator and Loan Administrator are the same person.
As Loan Administrator you are responsible for, at a minimum:
• Reviewing and approving (or denying) the participant's loan application;
• Setting the interest rate and term of the loan; and
• Determining the allowable amount of the loan.
You also should make sure the loan applicant understands the disadvantages to the applicant of 401k loans, that he or she can have only one loan outstanding at any one time, and that a loan may be granted no more than once in any 12-month period.
One disadvantage to the company is that processing loans can be time-consuming and therefore costly. However, you are allowed to set reasonable annual fees ($25 to $30) for setting up and administering loans and to pass these fees on to the employee. These fees cannot be deducted from either the loan repayments or the employee's normal 401k contributions. They must be paid using after-tax money. We recommend a written check issued by the borrower and made payable to the sponsor. The loan fees may be used by the sponsor to offset routine 401k plan costs.
The customized 401k Loan Pac is a complete package that includes loan policy guidelines, terms and conditions, step-by-step procedures, and all the necessary forms. It is important that you thoroughly familiarize yourselves with the contents of this package before giving it to an employee, and that you explain the loan provisions of your 401k plan to the employee.
IMPORTANT!!!It is especially critical that the applicant realize the importance of the promissory note. This note must be signed before any loan can be finalized. If a participant fails to complete the promissory note, the loan could be considered an early distribution from the plan and taxes would apply.
An employee cannot take a loan in excess of the allowable maximum (50 percent of the vested account balance up to $50,000). In addition, your plan administration software applies the following restrictions:
• Minimum loan amount is $1,000.
• Loans for amounts between $1,000 and $1,999 must be repaid within 12 months or less.
• Loans for amounts between $2,000 and $2,999 must be repaid within 36 months or less.
• Loans between $3,000 and $50,000 must be repaid within 60 months or less.
• Ten-year loans for residences cannot be for less than $6,000 and not more than $50,000.
Employer qualified non-elective contributions (QNECs) can be considered a part of the employee's account value for a loan.
Terminating Employment When There's an Outstanding Loan
An employee who terminates employment before the loan is paid off has two options:
1. Pay in full the outstanding loan balance, or
2. Have the outstanding balance treated as a taxable distribution.
In the latter case, the balance is reported to the IRS on a 1099-R as taxable income for the current year. The employee is responsible, not only for the income tax on this income, but also for a 10% penalty for a premature distribution (if he or she is less than 59 1/2 years of age).
A grace period of up to 90 days is generally allowed. If the employee has more than $1,000 in his or her account, including the loan, and during this grace period does not repay the loan or elect to have the balance treated as taxable income, the loan is treated as a taxable distribution and reported to the IRS on a 1099-R.
If the employee has less than $1,000 in his or her account, including the loan, and does not elect either of the above options during the grace period, you may make a distribution of his or her entire vested account balance. The mandatory 20% federal withholding applies, and the amount reported on the 1099-R includes the employee's vested account balance plus the remainder of the outstanding loan principal.
Print out a 401k Loan Pac from Reports and give it to the employee who requests it. Explain to the employee the specific terms and conditions of your company's loan policy and the forms included in the Loan Pac. The Loan Pac is completed by the employee and returned to you. You review and approve the request, and then review with the employee the amount, rate, and term of the loan. If the loan is denied, the employee must be informed in writing, including the basis for denial.
Entering Approved Loans Into the System
To enter approved loans into your plan administration software system:
1. From the “Welcome. . .” menu, choose Employee Information. Highlight the employee's name; then click on Loans. The “Employee Loans” window will appear. Click on New and the “New Loan” window appears.
2. In the “New Loan” window, if this is a loan for a primary residence, check Prim. Residence. The investment account company can supply you with the current value of the employee's account; enter this amount in the Enter Acct. Value field (your plan administration software will not allow a loan that is more than 50 percent of the account value). Then enter the loan start date, principal amount, interest rate, and term of loan (in months). Click on Post.
The software calculates the amortized monthly payment, desired payment, and two payoff options and displays this information in the “Employee Loans” window. The first payoff option is the balance due if the loan will be paid in full before the next month's processing; the second, if the loan will be paid in full after the next month's processing, with additional interest.
If an employee wishes to pay more than the amortized payment, he or she can. The additional payment will be applied to the principal. If the employee is paying back an additional $100 per month, for example, you can change the Desired Amount by increasing the total in that column by $100. This will be reflected in all future grids. You can also adjust the loan payment amount in the grid.
The Hold field in the Employee Loans grid is used if, for example, you enter the loan information before repayment starts or an employee terminates. Click on the Hold field and “Hold” appears in red. Also, an “H” appears in the left margin of the “Current Loans” report generated by your plan administration software (see below and Chapter 9).
Entering Loans and Repayments Into Your Payroll Software
Most payroll software programs have the capacity to track 401k loans: programs calculate and deduct loan repayments as well as 401k contributions from a participant's pay each month. Please refer to your payroll organization for details.
Entering Monthly Loan Repayments Into the System
Monthly loan repayments are listed on the form you receive from Payroll at the end of each month and are processed along with the other monthly updates through the "Processing" and the "Process Monthly Contributions" windows. When you have finished processing the month, the “Employee Loans” window reflects the monthly update. The employee is kept apprised of the loan payments and balance by means of the monthly contributions report output by your plan administration software.
Interfacing with the Investment Account Company
Upon your request for a new employee loan (via the Asset Liquidation Authorization form), the investment account company liquidates the amount requested and sends the proceeds to you, the Plan Administrator. A waiver of fees is requested of the investment account company because it is a loan.
The check is deposited into the plan trust bank account and a check is written to the employee out of the plan trust bank account.
Loan repayments are handled just like the allocations. One check is written to each investment account company accompanied by a report which shows where the money goes.
To view a list of current loans in the system…
1. Choose Reports from the “Welcome…” menu. Choose Current Loans from the alphabetical list in the right-hand box. Click on Print.
2. The report lists each employee, his/her social security number, the amount of the loan, the start date, the interest rate, the term, the amortized payment, and the desired payment for each loan outstanding as of the date of the report. If there is a hold on a loan, an “H” is shown in the right-hand margin.
3. The report also lists the total number of loans currently outstanding.
