How do I Correct a 401(k) Plan Loan Error?

Many 401(k) plans allow loans to participants.  However, failure to properly administer plan loans is a common 401(k) compliance issue. Before distributing loans to participants, plan sponsors should ensure that their plan document: (i) allows plan loans and (ii) appropriately reflects the requirements prescribed under Internal Revenue Code (the “Code”) Section 72(p). What are the loan requirements under the Internal Revenue Code? In order to avoid treatment of a loan under a 401(k) plan as a taxable distribution, such loan must satisfy certain requirements under Code Section 72(p) including:

1. The loan must be a legally enforceable agreement.The agreement can be a paper or electronic document stating the date and amount of the loan.  The agreement must bind the participant to a repayment schedule.
2. The amount of the loan cannot be more than 50% of the participant’s vested account balance up to a maximum of $50,000.If the participant previously took out another loan from the 401(k) plan, the $50,000 limit is reduced by the highest outstanding loan balance during the one-year period ending on the date before the new loan.
3. The loan agreement must require the participant to make level amortized payments at least quarterly.Each repayment should include an allocation of principal and interest.  Generally, a 401(k) plan loan must be repaid within five years unless the participant uses the loan to purchase his or her main home.
4. Exception for leave of absence. Code Section 72(p) provides an exception to the loan repayment schedule for participants who take a leave of absence. The 401(k) plan may suspend a loan for one year while the participant is on a leave of absence.  However, the 401(k) plan may not extend the loan’s maximum five-year repayment period. Upon return from leave of absence, the participant must ensure repayment within the maximum five-year repayment period by either: (i) increasing the payments over the remaining term of loan, or (ii) making a catch up payment for the missed payments during the leave of absence.

What are the correction procedures for a 401(k) plan loan error? It is important that 401(k) plans have a system in place to ensure that the terms of a participant loan and its repayments follow the requirements under Code Section 72(p) so that the loan is not treated as a taxable distribution.  The most common 401(k) plan loan and correction requirements are as follows:

1. Loan that exceeds the dollar limit.  The participant must repay the excess loan amount and amortize the remaining principal balance (if any) as of the repayment date over the original loan’s remaining period.
2. Loan that exceeds the maximum loan period.The outstanding amount of the loan is reamortized over the maximum remaining period allowed under Code Section 72(p) (5 years) from the original loan date.
3. Loan that is in default because of failure to make timely payments. The participant must either:

• Make a lump sum payment for the missed installments (adjusted for interest);
• Reamortize the outstanding balance of the loan, resulting in higher payments going forward; or
• A combination of a make-up payment and reamortization of the loan.

The plan administrator can preserve the tax exemption for a 401(k) plan loan in certain circumstances.  The plan administrator may allow for a “cure period” that would permit a participant to make up for a missed payment.  The cure period cannot go beyond the end of the second quarter following the quarter in which the missed payment was due.  If the loan violated the terms of the 401(k) plan document or Code Section 72(p), the plan sponsor can either: (i) use the Voluntary Correction Program (VCP) to permit employees to include the amount of loan in income in the year of correction, or (ii) request relief from reporting the loans as taxable distributions to participant under the VCP. This summary is intended to be informational and does not constitute legal advice. Hamby Benefits Law, LLC recommends that you consult ERISA legal counsel to assist (i) in reviewing 401(k) plan documents to ensure compliance with the requirements for loans under Code Section 72(p), and (ii) with administration and implementation of correction procedures in the event of a 401(k) plan loan error.