The IRS has recently published information on the most common 401k participant loan issues companies’ face during the year. The most common issue identified was a lack of procedures to ensure participant loans are being properly made through payroll deductions. To help clients understand how these loans need to be managed, JLK Rosenberger wants you to be aware to help avoid similar issues with your retirement plan.
The most common mistake occurs when companies set up automatic payroll deductions as loan payments. The IRS found that often times there is no process in place to ensure the payroll department receives the request. As a result, there is the opportunity for error in setting up and managing the repayment process. This can be disastrous for the participant because missing loan payments can result in the reclassification of the loan to a distribution.
Example: On June 1, 2011, Bridget took a $10,000 loan from her 401k plan. The interest rate on the loan was 8%; it was for a five-year period and required monthly payments of $203. Loans payments were to be made through payroll withholding. (It’s important to note that the plan did not have a cure period). Through some unknown error, Bridget’s loan information was never forwarded to the payroll department. As a result, she was not making the required loan payment. The problem was uncovered in December 2011 during a review of the plan’s records. Since no payments were ever made, the terms of the loan were violated and the entire $10,667 (including interest) will now have to be recognized as (a distribution) income on Bridget’s 1040.
Resolving the Issue
Remember the trigger event which creates a taxable distribution occurs when required payments are not received. If this has happened to one of your plan participants, there is a way to resolve the situation. An employer can get relief from the IRS under its Voluntary Correct Program (VCP). Through this program the IRS will allow the employer to correct the mistake and thereby relief the participant of distribution classification. Following the example above, if the failure was corrected on January 1, 2012, the plan administrator could have resolved the issue in the following ways:
- Lump Sum Payment – Bridget could have made a lump sum payment for the missed installments (including adjustments for interest) and continued making the installment payments for the rest of the loan.
- Loan Reamoritzation – The plan administrator could reamortize the balance of the loan, increasing the monthly payments.
- Partial Lump Sum Payment – The employee could have made a partial lump sum payment to make up for some of the missed payments due to the plan. The plan administrator could then have reamortized the balance of the loan, creating a new monthly payment amount for the employee to pay.
Best Practices to Avoid Errors
Remember as the number of participants in your plan increases, the opportunity for participant loan issues also increases. We suggest implementing the following to avoid issues in the future, including:
- Forward Loan Information to Payroll – An important way to avoid missed loan payments withheld from payroll is to create a process that documents payroll received information about the loan prior to the issuance of the loan check. Consider creating an approval form that requires the approval of the plan administrator and an authorized payroll employee, before a check is issued. In this way, before the loan is even issued the payroll department is aware that a withholding amount should be reflected on the employees’ paycheck every period. If the withholding does not appear then payroll can work proactively to ensure the issue is addressed.
- Implement a Cure Period – The second way to protect participants from this situation is to implement a provision that ensures a loan does not become a “deemed distribution” until the end of the calendar quarter, following the quarter in which the payment was missed. Known as a cure period, this gives the plan administrator the opportunity to take the corrective action within a reasonable timeframe. Without the cure period, there is very little time for the plan administrator to correct issues and provide the plan participant with a reasonable resolution to the situation. By building in this additional time, the plan administrator will be able to more effectively manage this aspect of the plan’s benefits.
Take the Next Steps
If your company has experienced issues with participant loans or would like assistance with Voluntary Correction Program items, we can help! We work with plan sponsors across the West Coast to ensure all aspects of their plan are in compliance. To determine if your company qualifies 401k loans and proper procedures, please contact JLK Rosenberger at 949-860-9902, or click here to contact us.