401(k) Loans

[Guest smill014]

Could someone please point to the reg that allows (or prohibits) a terminated employee from taking out a loan on his 401(k)?

[ERISAnut]

There is no such reg. This is purely an issue of the particular plan's loan policy. 72(p) doesn't engage in whether the employee is terminated or not.

[masteff]

In slightly different words in case it helps for clarity, the relevant regs are under 1.72(p)-1, however those address "participants and beneficiaries", not "active" vs "terminated".

[Guest Sieve]

At the same time, smill014, a plan is not required to provide loans to terminated participants just because it provides loans to active participants. The plan can, by its terms, specifically require a participant to be employed by the employer in order to take out a loan.

[J Simmons]

Larry, is disallowing loans to terminated employees who yet have benefits in the plan subject to BRF testing?

[ERISAnut]

Larry, is disallowing loans to terminated employees who yet have benefits in the plan subject to BRF testing?

No.

However, imposing a minimum loan amount in excess of $1,000 would be.

[Guest Sieve]

ERISAnut is correct. Loan provisions are subject to BRF testing (see Treas. Reg. Section 1.401(a)(4)-4(e)(3)(iii)), but only with regard to employees (see reg. -4(e)(3)(i))--so former employee can be treated differently. The $1,000 minimum loan provision, on the other hand, is in the DOL regs and relates to whether a Plan loan is made available on a "reasonably equivalent" basis so that it is exempt from prohibited transaction rules. (I had a client who once raised the loan minimum to $2,000 with the approval of the TPA, so I called the DOL to discuss what test should be used to determine if a failure of the $1,000 minimum was discriminatory, and was told that there is no specific test. So, I prepared a sort-of 410(b) test to show (in the event of audit) that the lost loan opportunity to those whose account balance was between $2,000 and $4,000 did not discriminate significantly in favor of HCEs, since the $1,000 minimum loan floor is a safe harbor and is not an absolute limit. DOL Reg. Section 2550.408b-1(b)(2).)

[KJohnson]

My recollection was that the thought was that the reasonably equivalent rule generally required that loans also be available to former employees as well as to active employees but in an advisory opinion letter in the late 80's DOL said that availability of loans could be restricted to parties in interest. All employees of the plan sponsor are parties in interest. Former employees who are still plan participants are generally not except if they fall under some other category as a party in interest such as they still have the requisite ownerhsip to make them a party in interest, remain a director of the corporation or are a party in interest through some type of family relationship. So I guess on a hyper technical basis restricting loans to active employees might violate DOL rules if you don't also allow loans for the rare terminated employee who remains a party in interest.

[Guest mjb]

My recollection was that the thought was that the reasonably equivalent rule generally required that loans also be available to former employees as well as to active employees but in an advisory opinion letter in the late 80's DOL said that availability of loans could be restricted to parties in interest. All employees of the plan sponsor are parties in interest. Former employees who are still plan participants are generally not except if they fall under some other category as a party in interest such as they still have the requisite ownerhsip to make them a party in interest, remain a director of the corporation or are a party in interest through some type of family relationship. So I guess on a hyper technical basis restricting loans to active employees might violate DOL rules if you don't also allow loans for the rare terminated employee who remains a party in interest.

what if the plan requires that all loans be repaid by payroll deduction?

[QDROphile]

A plan can't have that provision, at least as applied to parties in interest who are not employees.

[Guest mjb]

A plan can't have that provision, at least as applied to parties in interest who are not employees.

why not? I have never see a plan document which provides an exemption from payroll withholding for loans to terminated participants who are parties in interest because the plans do not have the capability to procees loan payments manually.

[Kevin C]

Sieve,

If the minimum loan amount is greater than $1,000, how does that comply with 2550.408b-1(b)(1)(ii) and (iii)? I don't see how you can with a minimum loan amount unless you qualify for the exemption in (2).

(b) Reasonably Equivalent Basis.

(1) Loans will not be considered to have been made available to participants and beneficiaries on a reasonably equivalent basis unless:

(i) Such loans are available to all plan participants and beneficiaries without regard to any individual's race, color, religion, sex, age or national origin;

(ii) In making such loans, consideration has been given only to those factors which would be considered in a normal commercial setting by an entity in the business of making similar types of loans. Such factors may include the applicant's creditworthiness and financial need; and

(iii) An evaluation of all relevant facts and circumstances indicates that, in actual practice, loans are not unreasonably withheld from any applicant.

(2) A participant loan program will not fail the requirement of paragraph (b)(1) of this section or §2550.408b-1© if the program establishes a minimum loan amount of up to $1,000, provided that the loans granted meet the requirements of §2550.408b-1(f).

[Guest Sieve]

Kevin C -- The loan provision you point to in ERISA simply says that "a participant loan program will not fail the requirements . . . if . . .". It therefore is seen as a safe harbor--i.e., a $1,000 minimum will NOT violate the PT exemption requirements--and leaves open the possibility that a higher loan minimum still might be OK. The reg does not say that a loan minimum in excess of $1,000 will cause the exemption to be lost, nor does it say that a loan minimum in excess of $1,000 is not permitted--just that a loan minimum of $1,000 is automatically treated as not violating the PT exemption. My contact at the DOL agreed with that interpretation, and I was glad because how else do you correct, operationally, a failure of DOL loan requirements after 2 or 3 years of people NOT requesting loans because the minimum was announced to be $2,000 rather than $1,000?

[Kevin C]

Sieve,

I was asking how a $2,000 or higher minimum loan amount would comply with:

(ii) In making such loans, consideration has been given only to those factors which would be considered in a normal commercial setting by an entity in the business of making similar types of loans. Such factors may include the applicant's creditworthiness and financial need; and

(iii) An evaluation of all relevant facts and circumstances indicates that, in actual practice, loans are not unreasonably withheld from any applicant.

I realize what (b)(2) says, but the loan program still has to comply with the requirements of (b)(1). If the loan program doesn't meet the reg requirements, aren't the loans that were made prohibited transactions? If the loans are PTs, what is there to correct for the people that did not get loans?

If $2,000 is ok, then how about $3,000? $4,000? $10,000? Where do you draw the line?

[J Simmons]

Hey, Kevin C,

Suppose that the plan is frozen, the minimum amount of vested benefits that any one employee has is $20,000. Then a $10,000 minimum would make the loans available to all, even if loans are also limited to 1/2 of the vested accrued benefit. Under that scenario, it would look like §2550.408b-1(b)(1) is satisfied.

[Kevin C]

J Simmons,

I'm not so sure about that. (b)(1) has three sub-parts and all three must be met. Would requiring that the loan be at least $10,000 really be only considering factors that would be considered in a normal commercial setting? I am looking at the minimum loan amount as one of the factors being used to decide if the requested loan will be granted.

If it is ok, then what happens when the employer foolishly rehires the guy who terminated three years ago when he was 80% vested and he repays the $2,500 distribution he received to get his forfeitures restored?

If the minimum loan amount is $1,000 and someone requests a $500 loan, the loan is denied. In that case, (b)(2) says the minimum loan amount doesn't cause us to fail to satisfy (b)(1). With a higher minimum loan amount, you don't get the exemption from (b)(1).

[Guest Sieve]

Kevin --

You're right that a minimum loan amount higher than $1,000 potentially will impact the determination of whether a loan is available on a "reasonably equivalent basis" under -1(b)(1). However, to suggest that the loan minimum should never be higher than $1,000 because of the inability to be able to draw an appropriate line is, I would suggest, a bit overly broad. Nevertheless, it certainly would be a facts and circumstances determination, and you'd have to make that decision based on your best guess. How long, for example, does it take people to get from $2,000 in their account balance (for a $1,000 loan) to $6,000 (for a $3,000 loan)? How many people will be denied loans just because the minimum is so high and their income or creditworthiness so low? etc., etc. Frankly, I can't off-hand imagine a situation in which I would either suggest a higher minimum loan amount or would agree that a higher minimum loan amount would still meet DOL requirements--at least, I can't think of a situation where there'd be enough certainty to make that line clear. I see no reason to move off the $1,000 number (especially in the current environment where only the borrower bears the adminisrative cost of the loan).

We can talk theory about what kinds of lines to draw, and for which plan demographic a higher minimum loan might make sense, forever. However, in my situation, Kevin, it already was a done deal. The plan only came to me after the error had existed for a number of years, so I had to draw up an argument supporting what had already been done rather than prepare an argument to support making a decision which was to be applied in the future. I simply did the homework necessary to show, if asked on audit, that only a few NHCEs were denied the opportunity to borrow (i.e., in my case, because they had an account balance $2,000 or more but less than $4,000--those who theoretically were eligible for a $1,000 loan but not a $2,000 loan). As it turns out, that was a very small percentage of NHCEs, so I will take the position, if requested, that the adverse impact of the ill-advised loan provision was, in fact, de minimus. I am comfortable with what I found out. Will I try to come up with some other arguments if the client is audited and the issue is raised by the DOL agent? Sure. Any suggestions?

[J Simmons]

J Simmons,

I'm not so sure about that. (b)(1) has three sub-parts and all three must be met. Would requiring that the loan be at least $10,000 really be only considering factors that would be considered in a normal commercial setting? I am looking at the minimum loan amount as one of the factors being used to decide if the requested loan will be granted.

If it is ok, then what happens when the employer foolishly rehires the guy who terminated three years ago when he was 80% vested and he repays the $2,500 distribution he received to get his forfeitures restored?

If the minimum loan amount is $1,000 and someone requests a $500 loan, the loan is denied. In that case, (b)(2) says the minimum loan amount doesn't cause us to fail to satisfy (b)(1). With a higher minimum loan amount, you don't get the exemption from (b)(1).

I agree, Kevin, but availability is the ultimate touchstone of those regs. I suppose that if that the re-hired employee repays into the plan his $2,500 and gets his $500 forfeited restored, for a total of $3,000 in benefits, the plan could then amend the $10,000 floor for loans to $1,500. In my scenario, no employee would be denied a loan because of the floor amount. It would not be a factor inhibiting availability.

[Guest Sieve]

John --

No loan would be denied in your scenario if the only thing considered is the size of the account balance. I think it's true, however, that some plans actually look into creditworthiness (which can be, but is not required to be, considered under -1(b)(1)(ii)). Therefore, if a minimum loan floor in exces of $1,000 is high enough that a creditworthiness determinination disqualifies a participant from receiving the minimum loan amount, then I would agree with Kevin that the PT exemption would not apply due to the high loan minimum causing the loan not to be available on a reasonably equivalent basis.

That being said, I have seen creditworthiness plan language, but never in a Plan that I've been involved with. My plans, no doubt like yours, automatically give a loan if the account balance is at least twice the size of the amount of the loan--not even considering for a minute whether the $25,000/yr. worker can conceivably afford the loan payments.

[Kevin C]

IRS and DOL auditors have a significant amount of discretion in how they address problems they find, or think they find. We have had ones that insist there is a problem when there is not one. We've also had ones that were extremely reasonable when there was a legitimate issue. In a couple of cases, the correction method they suggested did not follow the letter of the rules. They were more concerned with making sure the NHCE participants were not harmed than they were about dotting the i's and crossing the t's.

If I were in your situation and the plan was audited, I would take the same approach.

We talked with a prospective client last month with a plan that had a $2,500 minimum loan amount. When I told him they can't do that, he laughed and said it used to be a $5,000 minimum. Hmm, I wonder why they didn't hire us?