Editor’s note: This is the first in a two-part series on participant loans. It features insights and suggestions from Joni Jennings, Newfront’s Head of Pension Services Compliance.

Whether or not to include participants’ ability to borrow from their 401(k) in the plan? This is the fundamental question an employer faces regarding the loans and the plan, but it is by no means all an employer should consider, a compliance officer suggests.

Deciding whether or not to include language in the plan that allows participants to take out loans is just the start, says Joni Jennings, chief pension services compliance officer at Newfront, in “401(k)ology — Participant Loans (Part 1).”

“The decision-making process to include loans in the 401(k) plan often comes down to a basic ‘yes/no’ question when the employer enters into the agreement to adopt the plan,” says Jennings, but after that, many employers don’t. continue, then review the parameters of a loan program, such as the number of loans a participant can have outstanding at one time, the interest charged, and the minimum loan amount. “These are important compliance and trust issues that employers should consider when deciding whether or not to include a participant loan program in the company’s 401(k),” she writes.

follow the rules

Jennings notes that there are three particularly important rules regarding participant loans.

1. Anti-alienation. Generally, 401(k) plan benefits should only be used for retirement benefits; however, Participant Loans secured by a Participant’s Acquired Account Balance that are not Prohibited Transactions are an exception to this rule.

2. Prohibited Transactions. Qualified plans cannot provide loans to disqualified individuals unless there is a prohibited transaction exemption.

3. Taxable Distributions. Distributions from a 401(k) are generally taxable. But this does not apply to participant loans from a 401(k) as long as the maximum loan outstanding is the lesser of $50,000 or one-half of the participant’s vested balance and the participant repays the loan within five years – although the participant may take longer than if they were using it to purchase a principal residence.

The plan document

Jennings suggests that with respect to diet loans, a diet document includes provisions such as:

• stating that participant loans are permitted;
• state that plan trustees are responsible for establishing a written loan policy; and
• specific parameters for loans.

Plan Loan Policy

A plan document, Jennings explains, will typically include language indicating that 401(k) participant loans will be permitted, and will include a loan policy that will set parameters for them. Such a policy, she says, is a “first line of defense” against participant loan errors and will help ensure that participant loans are properly maintained.

A loan policy, says Jennings, is considered an extension of a plan document. She notes that it must be written down and given to plan members. Many practitioners include the plan’s loan policy in the summary plan description (SPD) or as an addendum to it, she adds.

Jennings suggests that these provisions be part of a loan policy:

• clarify who has the authority to administer the loan program;
• the types of loans allowed;
• the amount that can be taken out as a loan and the minimum loan amount;
• the parameters of the loans to be used for a principal residence;
• discussion of how interest rates will be determined;
• collateral used to secure a loan;
• the maximum number of outstanding loans a participant can have;
• whether refinancing is allowed, and if so, what are the options;
• costs;
• application procedures;
• loan approval and rejection process;
• a requirement that a participant sign a promissory note;
• how a participant should repay a loan; and
• default and recovery period.

The essential

Jennings urges an employer to know the rules and have policies and procedures in place to maintain the program.

It is of the utmost importance, cautions Jennings, that plan sponsors fulfill their responsibility to comply with the legal requirements that govern member loans. Failure to do so, she warns, could result in borrowing participants being taxed and plan trustees engaging in a prohibited transaction.

Next installment: Additional Diet Loan Considerations