LOANS FROM QUALIFIED PLANS

The law permits loans, within limits, to participants in regular qualified plans and Section 403(b) tax-deferred annuity plans. However, a participant cannot borrow from a plan unless the plan document specifically permits loans, and as discussed below, loan provisions may not be appropriate for all plans. Loans from IRAs and SEPs are effectively prohibited; they are treated as taxable distributions and may be subject to penalties for premature distribution. Also, loans from a qualified plan to an owner/employee (a proprietor or more than 10 percent partner in an unincorporated business) or to an employee of an S corporation who is a more-than-5-percent shareholder in the corporation are prohibited transactions subject to the prohibited transaction penalties.

Terms of Loans

To obtain loan treatment, the loan must be repayable by its terms within five years. The rule noted above for reducing the $50,000 limit by the loan balance in the preceding year was designed to prevent avoidance of the five-year limit by simply repaying and then immediately reborrowing the same amount every five years. The five-year requirement does not apply to any loan used to acquire a principal residence of the participant.

Transactions with an effect similar to that of loans (for example, the pledging of an interest in a qualified plan or a loan made against an insurance contract purchased by a qualified plan) are also covered by the loan limitations and rules.

If the plan permits loans, they must be made available on a nondiscriminatory basis. Also, the loans must be adequately secured and bear a reasonable rate of interest. Usually, the security for a plan loan is simply the participant's vested accrued plan benefit. Interest on the loan is generally consumer interest that is not deductible as an itemized deduction unless secured by a home mortgage. However, if the loan is to a key employee as defined in the top-heavy rules or is secured by 401(k) or 403(b) elective deferrals, interest is not deductible in any event.

Any loan that does not meet these requirements will be treated as a current distribution and may be currently taxable to the employee when received.

Should the Plan Permit Loans?

Whether the plan should permit loans depends on the employer's objectives for the plan. Plan loan provisions are often desired by the controlling employees of closely held businesses because a plan loan provides the advantage of tax sheltering the plan funds without losing control of the cash. However, the same considerations may make plan loans desirable for regular employees as well. A disadvantage of plan loans is that if they are too extensively utilized, they deplete the plan funds available for investment. More fundamentally, however, plan loan provisions are inconsistent with a primary plan objective of providing retirement security. Thus, they are less common in pension plans than in profit-sharing plans. Plan loan provisions are particularly uncommon in defined-benefit plans because such plans have no individual participant accounts; it is complicated to convert a participant's vested accrued benefit to a cash equivalent at a given time to determine the amount of loan that can be allowed. Plan loans also add significant administrative costs to the plan.