401(k) administrators play many roles — including, often somewhat reluctantly, banker.
In addition to all other duties, plan administrators are responsible for the administration of 401(k) retirement plan loans. This includes…
Making sure that loans taken from the plan comply with the plan documents & IRS rules
- Setting up repayment withholdings in payroll
- Monitoring loan repayments
- Ensuring that the loan is repaid or properly handled when an employee who has a loan leaves
If 401(k) loans are common in your plan, this can be a lot. And chances are you’re already pretty overworked.
We’ll take you through the IRS’s 401(k) loan rules and regulations to keep you from tripping up.
A Quick Overview of 401(k) Loans
A 401(k) loan is one that’s borrowed from a participant’s vested retirement account assets — basically, money they borrow from themselves.
When your employee wants to borrow from their 401(k), they’ll request the loan through the recordkeeper’s website. When this happens, you’ll be sent an alert. Depending on the recordkeeper, you may have to review the request and decide whether or not to approve it.
Once the request is approved, the recordkeeper will create a written loan agreement and amortization schedule and will distribute the funds. You will then need to set up the loan repayment withholdings in payroll according to the schedule provided by the recordkeeper.
IRS 401(k) Loan Rules
Like all things retirement-related 401(k) loans come with rules (and consequences for breaking them) — courtesy of the Internal Revenue Service.
The rules are set up to give participants access to their funds, while still protecting their retirement savings. As such, the rules revolve around approving loans and setting up payroll to correctly handle the loan repayments.
IRS Rules for 401(k) Loan Approvals
1. Make Sure Your Plan Allows Loans
While the IRS has specific rules for 401(k) loans, not all plans allow loans. So your first step is to check your plan documents to make sure that loans are even allowed.
2. Abide by the Maximum Loan Amount
The maximum amount that can be taken out as a loan is $50,000 OR 50% of the participant’s vested account balance, whichever is less.
3. Lay It Out in a Loan Agreement
A handshake isn’t gonna cut it. Each 401(k) loan has to be laid out in a paper or electronic document that details the date and amount of the loan, and binds the participant to a repayment schedule.
4. Be Reasonable with Rates and Repayment
The IRS mandates that 401(k) loans must be secured and that the interest rate and repayment schedule are “commercially reasonable” — i.e no worse than you’d get from a lender on the market.
5. Do Things Promptly
This isn’t technically an IRS rule — but it is still important. There can be several different people, departments, or companies to get through before loan approval is finalized, but time is often of the essence. This process can take anywhere from a day to several weeks, but too long may cause employee complaints to the DoL or IRS.
Rules for Payroll and 401(k) Loans
1. Stick To the Repayment Schedule
Each payment should be generally equal amounts, paid at least every quarter, with the loan being fully repaid within five years*.
As the plan administrator, you’re responsible for correctly setting up payment schedules. If a participant changes their repayment rate or makes a payment directly to the recordkeeper, the withholding schedule will have to be adjusted accordingly before you run payroll next.
*Note: The IRS lets you waive the five-year repayment deadline if the loan is used to purchase a primary residence.
2. Don’t Cause a Loan to Default
Defaulting on any loan is a bad idea - and a 401(k) loan is no exception.
As plan administrator, if a participant defaults on their loan because you fail to properly set up repayment withholdings, you’ll be responsible for paying off the remainder of the loan.
If a defaulted loan isn't taken care of, you could be looking at the ultimate panic moment in 401(k) administration — potential 401(k) plan disqualification.
401(k) loans are quite bit of work as well as a pretty hefty scoop of responsibility. As the administrator for the plan, you’re not only responsible for issuing that loan, you’re signed on for any mistakes that you make during its repayment.
Let’s go over a few of the common ones below...
Common Mistakes With 401(k) Loans
When it comes to 401(k) loans, it’s really easy to make a mistake. Here are some of the most common:
Insufficient Loan Payment
If a loan payment is too small due to an administrative error, your company is responsible for making up the difference.
Missed Loan Payment
If a participant misses a loan payment because of an administrative error, your company could be on the hook for making the payment on the participant’s behalf.
If the participant misses enough payments, the loan goes into default. If this happens due to an administrative error, your company could be responsible for paying the remaining loan balance in its entirety.
If loan repayment withholdings aren’t stopped on time, you’ll have to run a payroll reversal with the recordkeeper and refund the money to the participant.
As in any payroll-related 401(k) process, mistakes are very common and super easy to make. In our experience, the best way to avoid them is with a complete integration between your payroll and recordkeeping systems. In particular, you’ll want an integration that has checks and balances in place to ensure that loan repayments are set up properly.