Increasing Loan Interest Rate

[austin3515]

Have a new client that uses prime for the loan interest rate. It's a fairly big plan (few hundred actives) and a very active loan program. We're recommending that they go up to prime +1. Now when I have done this in the past we've just increased it, but I think this client is going to think this change is a big deal so what I am wondering is how have other people approached the transition, in terms of employee communications, and perhaps advance notice, etc (i.e., similar to a fee disclosure notice). I think the fee disclosures philosophy will be on the forefront of their minds...

[Belgarath]

I've never seen plan loans at prime rate. First, I might think about checking with the auditor for the 5500 forms to see if they think prime is acceptable. I guess I'm a little surprised that it hasn't been questioned (or perhaps it has, and they decided prime was ok). If so, I'd ask them to look at it again, and provide documentation/citation for that position.

I'd probably then ask if this decision was made in conjunction with or reviewed by tax/legal counsel. If so, I would ask to see the opinion, or try to discuss with that advisor.

Assuming the above isn't applicable or doesn't resolve anything, I'd then refer the client to 2550.408b-1(e). I find it very hard to believe that "persons in the business of lending money" would charge prime rate for loans which would be made under similar circumstances. But maybe I'm wrong...

And then I'd point out the consequences of having a loan program that fails to meet the Prohibited Transaction exemption rules.

But all done very carefully, of course, as I understand you don't want to alienate a new client and/or auditor/legal/tax counsel. Seems like the TPA is always the bad guy. Have fun!

(e) Reasonable rate of interest. A loan will be considered to bear a reasonable rate of interest if such loan provides the plan with a return commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances.

Example 1: Plan P makes a participant loan to A at the fixed interest rate of 8% for 5 years. The trustees, prior to making the loan, contacted two local banks to determine under what terms the banks would make a similar loan taking into account A's creditworthiness and the collateral offered. One bank would charge a variable rate of 10% adjusted monthly for a similar loan. The other bank would charge a fixed rate of 12% under similar circumstances. Under these facts, the loan to A would not bear a reasonable rate of interest because the loan did not provide P with a return commensurate with interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances. As a result, the loan would fail to meet the requirements of section 408(b)(1)(D) and would not be covered by the relief provided by section 408(b)(1) of the Act.

Example 2: Pursuant to the provisions of plan P's participant loan program, T, the trustee of P, approves a loan to M, a participant and party in interest with respect to P. At the time of execution, the loan meets all of the requirements of section 408(b)(1) of the Act. The loan agreement provides that at the end of two years M must pay the remaining balance in full or the parties may renew for an additional two year period. At the end of the initial two year period, the parties agree to renew the loan for an additional two years. At the time of renewal, however, A fails to adjust the interest rate charged on the loan in order to reflect current economic conditions. As a result, the interest rate on the renewal fails to provide a “reasonable rate of interest” as required by section 408(b)(1)(D) of the Act. Under such circumstances, the loan would not be exempt under section 408(b)(1) of the Act from the time of renewal.

Example 3: The documents governing plan P's participant loan program provide that loans must bear an interest rate no higher than the maximum interest rate permitted under State X's usury law. Pursuant to the loan program, P makes a participant loan to A, a plan participant, at a time when the interest rates charged by financial institutions in the community (not subject to the usury limit) for similar loans are higher than the usury limit. Under these circumstances, the loan would not bear a reasonable rate of interest because the loan does not provide P with a return commensurate with the interest rates charged by persons in the business of lending money under similar circumstances. In addition, participant loans that are artificially limited to the maximum usury ceiling then prevailing call into question the status of such loans under sections 403© and 404(a) where higher yielding comparable investment opportunities are available to the plan.

[Bird]

It's not a fee so I wouldn't worry about the formality of that. If the rate is in the SPD (and it shouldn't be, IMO, for this very reason) then that should be changed (SMM). Otherwise, change the loan policy/procedure and move on; I think you are only obligated to give that when someone asks for a loan.

If you want to do more than necessary, then hand out the new loan procedure, but be prepared for a flood of loan apps - no good deed goes unpunished.

[austin3515]

I'm down with everything you just said, I'm just trying to step into my clients shoes. They might be ok with a few more loans. I'm not sure there would be a "flood" on account of 1% more interest. Presumably people take the loans only when they need/want the money.

[Peter Gulia]

ERISA 408(b)(1)(D) and 29 C.F.R. 2550.408b-1(a)(1)(iv) call for "a reasonable rate of interest".

The rule's subsection (e) and its examples suggest that a fiduciary that sets the participant loan interest rate should see to it that the plan (practically, the borrowing participant's account) doesn't get a too-little investment return.

But nothing in the rule precludes an interest rate that is more than what a hypothetical bank would get.

A fiduciary might consider whether the exclusive purpose of providing retirement benefits to participants could better be met by a higher interest rate. Depending on the plan's particular facts and circumstances, participants (as a class) might benefit from a higher interest rate. Another plan's participants might benefit from the lowest rate that the fiduciary can defend as meeting the conditions of the statutory prohibited-transaction exemption.

[QDROphile]

At some point an interest rate would be high enough to inspire the IRS to assert that the arrangement provided for disguised contributions. Goldilocks is a good role model and commercial lending rates (although there are no similar loans on the market -- some old posts go into this in detail) are the standard. The IRS is more likely to go after individual or small professional organization plans with respect to loan hijinks.

[Peter Gulia]

QDROphile's point about too-high interest resulting in a disguised contribution is real.

A plan's administrator (without getting advice from anyone) had considered that a participant loan is a hybrid between an unsecured loan and a semi-secured loan (semi-secured because the participant's investments can lose value, and the set-off right is delayed until the participant's severance from employment), and had interpreted the idea of "loans [that] would be made under similar circumstances" to look to credit-card rates.

Later, an IRS examiner informally raised the idea that high interest on repayment of a participant loan allowed participants to put more money into tax deferral. I'll never know whether the IRS would have pursued that idea; the examination closed without any handling of that issue.

[austin3515]

Perhaps they forgot that the interest is actually taxed twice.

[jpod]

Yeah, why would you want to charge yourself a high interest rate only to be taxed on it on the back-end? It is in no way shape or form economically comparable to an after-tax contribution. Perhaps if the interest is going to be in your account for 40+ years the tax deferral on the subsequent earnings on that interest will make it beneficial, but I am skeptical and too lazy to do the math myself.

[Peter Gulia]

Perhaps the IRS was wise in closing its examination without any handling of an examiner's disguised-contributions theory.

However, that exam was before the Roth-ing era.

[QDROphile]

I thought the "loan interest is taxed twice" misconception had been laid to rest. Don't bother arguing. I am taking the same position about debate as Stephen Jay Gould did with evolution deniers. You can talk among yourselves.

[QDROphile]

I thought the "loan interest is taxed twice" misconception had been laid to rest. Don't bother arguing. I am taking the same position about debate as Stephen Jay Gould did with evolution deniers. You can talk among yourselves.

[austin3515]

http://www.federalreserve.gov/pubs/feds/2008/200842/200842pap.pdf

Loan interest payments, on the other hand, can indeed be considered double-taxed under

traditional consumption tax principles—since interest payments are like new contributions, they should be made with pre-tax dollars and then taxed upon withdrawal. In practice, however, the double-taxation of loan interest relative to a consumption tax is offset by the break borrowers get on the timing of their tax payments: recall that rather than paying taxes on loan proceeds when they are distributed (i.e., consumed), borrowers pay the taxes gradually over the following five years as they repay the loan with after-tax dollars. The time value of these delayed tax payments offsets the double taxation of interest—perfectly so, if the discount rate is the pre-tax rate of return; only partially if the discount rate is lower. An algebraic illustration of the taxation of 401(k) loans is provided in Appendix 1.

Summary:

Because you are not taxed on the loan proceeds when you receive them, and repay these untaxed proceeds with after-tax dollars, these repayments are akin to paying the taxes you owed. They're saying that your tax advantage of a loan is the use of pre-tax money without paying taxes.

However, I have always said that the double taxation analysis is only relevant when compared with borrowing the money from another source outside the plan. If you took the same loan from that other source, and the rate of return is the same in your account is equal to the interest paid on the borrowing, you've still made the same total payments on the loan and still have the same amount of money in your 401(k) account.

And as I wrote this down, I said to myself, "self, if that is true then really was no difference at all in either strategy and you truly pay no more taxes in either situation. So maybe double taxation really is as described - a very convincing mirage... And if we've just proven that borrowing from your 401k results in no additional taxes paid as compared to borrowing a bank then perhaps there really is no double taxation on the interest."

Interesting...

[Bird]

I'm not sure there would be a "flood" on account of 1% more interest. Presumably people take the loans only when they need/want the money.

I meant that saying anything at all about a loan program will remind/inform people of its existence and all of a sudden there will be things that they need/want a little more badly.

[austin3515]

I meant that saying anything at all about a loan program will remind/inform people of its existence and all of a sudden there will be things that they need/want a little more badly.

Yes, this I can see...

[GMK]

interest rate would be high enough ... that the arrangement provided for disguised contributions.

Finally, a justification for a retirement plan to offer loans (assuming the plan has the expertise to administer loans).