Loan Interest Rate

A 403(b) plan would like to establish a loan interest rate of the prime lending rate, in effect as of the first day of each calendar quarter, plus 1%.

Do you see any problems with this policy?

IRS has verbally said on a call that we should be using Prime plus 2% but I see Prime plus 1% used all the time.  Make sure the rate is set of an individual loan.... in other words, no rate fluctuation once the loan is issued.

What if the loan interest rate is set at prime plus 1% at the beginning of the quarter, but the prime lending rate changes during the quarter.  However, the loan interest rate applied to loans during this time remains the same. I am concerned that this policy, of applying an interest constant for a calendar quarter, may run counter to DOL and IRS guidance that the “reasonableness” of an interest rate hinges on the determination of the prevailing market rate for similar loans. 

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I agree with Ms. Jensen. You see prime + 1% all the time and I know of no case or FSA or anything else that has ever challenged. Prime without 1% is what a bank in theory would use for its most credit-worthy customers. Given the relative security of a loan secured by the participant's own account balance and the low costs of foreclosure, how is the participant not a prime risk? Arguably, holding the rate steady for a quarter is more questionable if interest rates volatile to high side. Maybe say it's held steady for quarter, but subject to change if the plan administrator determines sufficient movement in interest rates to warrant.

The reality is you will never have a challenge from the authorities if you use prime plus 1 at the beginning of the quarter and hold steady, UNLESS there is a DRASTIC change in underlying rates during the quarter.  So if you use that, you should have a clause that says "subject to change if determined to be necessary by the plan administrator at time of loan".

Now, what I would suggest is why even have such a restriction.  Just say prime plus 1 at the time of the loan and leave it at that.  

On 4/26/2018 at 12:37 PM, Patricia Neal Jensen said:

IRS has verbally said on a call that we should be using Prime plus 2% but I see Prime plus 1% used all the time.  Make sure the rate is set of an individual loan.... in other words, no rate fluctuation once the loan is issued.

Obviously there are a lot of these calls with various people from the IRS but from my experience they have not gone as far saying "use Prime +2".  What I have heard is more along the lines of the IRS not endorsing a general policy of Prime +1 and in many cases Prime +2 is probably more reasonable.   That said, Prime +1 is what I see 99% of the time and I have never seen it be an issue on audit.

On 4/27/2018 at 5:22 PM, RatherBeGolfing said:

Obviously there are a lot of these calls with various people from the IRS but from my experience they have not gone as far saying "use Prime +2".  What I have heard is more along the lines of the IRS not endorsing a general policy of Prime +1 and in many cases Prime +2 is probably more reasonable.   That said, Prime +1 is what I see 99% of the time and I have never seen it be an issue on audit.

 

Yep.  That's the gist of the IRS phone forum on loans from September 2011.

Here is the salient paragraph:

Generally, the prime interest rate is a rate that banks only give to their very best customers and rare, very rare at that. For this reason as a general rule the Service generally considers prime plus 2% as a reasonable interest rate for participant loans, andI hope that helps you. Again, it’swww.federalreserve.gov/releases/h15, and this is used over and over and over again. All of our Internal Revenue agents in employee plans have been given this Web site to update their computer program that they use to calculate excise taxes for Form 5330.

Here's a link to the transcript:  https://www.irs.gov/pub/irs-tege/loans_phoneforum_transcript.pdf

That said, has anyone ever had prime +1% ever challenged?

9 minutes ago, BG5150 said:

Yep.  That's the gist of the IRS phone forum on loans from September 2011.

Here is the salient paragraph:

 

 

Here's a link to the transcript:  https://www.irs.gov/pub/irs-tege/loans_phoneforum_transcript.pdf

That said, has anyone ever had prime +1% ever challenged?

Thanks BG.  I remember that call now that I read the transcript.  

While I can't cite anything, I believe the IRS was pushed on this issue after the call and they reiterated that they don't back ANY particular rate as it depends on facts and circumstances. There were some pretty wild discussions on the ASPPA linkedin message boards at the the time.  

7 hours ago, BG5150 said:

Yep.  That's the gist of the IRS phone forum on loans from September 2011.

Here is the salient paragraph:

 

 

Here's a link to the transcript:  https://www.irs.gov/pub/irs-tege/loans_phoneforum_transcript.pdf

That said, has anyone ever had prime +1% ever challenged?

No; never.  And they never will because it is just not practical for the agent.  Remember, employee plan agents are NOT revenue agents; they are compliance agents and they will not get into a pissing contest with a plan administrator over whether it should be plus 1 or plus 2. It is not worth their effort. They want to CLOSE cases as fast as they can (that's how they get rated).