The Headache of Plan Loans

They often say that the road to hell is paved with good intentions. I don’t know who said it first (I heard it was originated with St. Bernard, the saint, not the dog), but perhaps they were a 401(k) plan sponsor that had a loan provision that did the plan a lot of harm.

While the idea of a retirement plan is for a savings vehicle and any access by the participant to that money defeats that purpose, I like offering the provision so that a participant can leverage it when they are in a cash bind. If it’s their money, they should be able to tap it if they really need it.

The problem with the loan provision is that I have come across too many compliance issues with it that has caused plan sponsors lots of grief. The grief usually involves the requirement that the loan be paid back in at least a quarterly basis or be considered a default, where the participant is required to receive a 1099 form for a deemed distribution. This error is as result of the third party administrator not keeping tabs on the loan. This may be a result of an incompetent administrator, incompetent plan sponsor, or as a result of the plan offering multiple loans. Any loan that does not meet any of the plan loan requirements is considered a prohibited transaction, which risks the plan’s tax qualification.

How to avoid the mess? I still think having a loan provision that offers multiple loans is a recipe for a disaster, I always recommend only allowing one loan outstanding at a time. In addition, make sure the TPA you work with has the software necessary to track these loans, as well as making sure the payroll information is correct for loan repayments.

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