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403(b) Plan Fix-It Guide - You haven’t limited loan amounts and enforced repayments as required under IRC Section 72(p)

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9) You haven’t limited loan amounts and enforced repayments as required under IRC Section 72(p).

Review the plan and all outstanding loan agreements to ensure that the loans comply with the plan terms and the employees are repaying their loans timely.

 

You may correct some failures by corrective repayment and/or modification of loan terms, if you make a submission under the Voluntary Correction Program.

 

Review and follow the plan provisions for making loans, including the amount of loan, loan terms and repayment terms. Make sure there are loan procedures in place.

 

Many 403(b) plan sponsors rely on many vendors to maintain their plan; however, the plan sponsor is always responsible for the plan’s operation, including its loan program. Plan sponsors are responsible for determining that each participant loan meets the requirements of the loan program and for enforcing loan repayments. “Hold harmless” agreements between a 403(b) plan sponsor and its vendors don’t lessen the plan sponsor’s responsibility.

Participant loans must meet a number of rules to prevent the law from treating them as a taxable distribution to the participant. There are two primary areas of concern.

1) Does the written 403(b) plan allow for participant loans?

The 403(b) written plan must first contain language allowing loans to participants. Since many 403(b) plans attempt to coordinate a loan program with many different vendors, it’s important to outline how the loan program is to be operated. This applies to 2009 and subsequent years.

Some plans have multiple vendors, some of whom allow plan loans and others who don’t. A written plan must ensure that the plan loans meet certain requirements. In addition, the underlying vendor documents that allow loans must be consistent with the written plan.

2) Do the participant loans meet the Internal Revenue Code Section 72(p) requirements?

In general, a loan to a participant must satisfy the following conditions to avoid being treated as a taxable distribution:

  • The plan must base the loan on a legally enforceable agreement.
    • This must generally be a paper or electronic document.
    • The loan terms must comply with the IRC Section 72(p)(2) requirements.
    • The loan agreement must include the date and amount of the loan, and a repayment schedule that would ensure that the participant repays the loan timely.

  • The plan administrator must limit the loan amount to the lesser of:
    • 50% of the participant’s vested account balance at the time of the loan, or
    • $50,000.
      • an exception allows a participant to borrow up to $10,000, even if it exceeds 50% of the participant’s account balance.
      • If the participant previously took out another loan, then the plan administrator must reduce the $50,000 limit of the loan by the highest amount owed by the participant on other participant loans from the plan (or any other plan of the employer or related employer) during the one-year period ending the day before the loan.

  • The participant must repay the loan within 5 years, unless the participant used the loan to purchase his or her principal residence.

  • Generally, the loan terms must require the participant to make substantially level payments, at least quarterly, over the life of the loan. (There are exceptions for a leave of absence or military service.)

How to find the mistake:

Review loan agreements and repayments to verify loans have met the rules to keep the law from treating them as taxable distributions. The added complexity of attempting to coordinate a large number of vendors greatly enhances the chances for error. You may want to take these steps to find mistakes in your loan program administration:

  • Review the loan requirements outlined in the written program (including, if necessary, the participant loan provisions in underlying vendor documents).
  • Review each participant loan agreement and determine if each loan was made following the rules of IRC Section 72(p).
    • Is each loan evidenced by a written loan agreement?
    • Is the loan amount within the $50,000/50% of the account balance limit?
    • Are participants required to repay loans within 5 years?
      • For each loan in excess of 5 years, is there documentation to indicate the participant used the loan to purchase his or her primary residence?

    • Does the repayment schedule require the participant to make level payments at least quarterly? Are the level amortization amounts properly calculated?
    • For each loan, determine that participants are timely making loan payments.
      • Does the plan allow for a “cure period” that provides a period of time for participants to make missed payments?
        • If the plan doesn’t provide for a cure period, one missed payment could put the loan into default.
        • If the plan provides for a cure period, the loan is in default if the participant hasn’t made payments before the end of the calendar quarter following the calendar quarter in which the participant missed the payment.

    • Is each loan made according to the plan terms?
      • A plan may have stricter limits than section 72(p) (for example, a plan may limit the amount to less than $50,000, or the term to less than five years or provide that participants may have only one loan outstanding). Loans that don’t meet the stricter plan limits may cause an operational problem.

    • Does each loan bear a reasonable interest rate?
      • Ensure that the interest rate charged on each loan is similar to what a participant would reasonably expect to receive from a financial institution for a secured personal loan.

    • Are loans made available on a reasonably equivalent basis?
    • Are loans adequately secured by the participant’s account balance?
      • Additional security may be required if a participant defaulted a previous loan.

  • For each loan, determine whether loan payments are being deposited to the plan timely.
    • Participant loan payments made through payroll withholding should be deposited into the plan as soon as administratively feasible.
    • Evaluate the payroll system to make certain participant loan payments are being withheld from the employee’s salary timely, in the proper amount and consistent with the loan terms.

How to fix the mistake:

Loan mistakes come in many varieties, each with their own correction attributes. The mistakes discussed below are the most common mistakes we see in VCP submissions and in 403(b) plan audits.

In 2009 and later plan years, the plan does not allow for any participant loans; however, participant loans are made - correct this mistake by making a retroactive plan amendment to provide for plan loans.

  • To correct under SCP or VCP, these loans must have been made available to all participants equally and have complied in operation with all IRC Section 72(p) requirements.
  • Plan sponsors may correct this mistake under SCP if proper practices and procedures are in place. Correction is also available under VCP or Audit CAP.
  • SCP for this mistake is only available under Revenue Procedure 2013-12.

Plan loan exceeds the dollar limit - this mistake is only correctible using VCP or Audit CAP - to correct, the participant must repay the excess loan amount, choosing among three repayment methods:

  • The participant would make a special supplemental loan payment equal to the original loan excess amount plus interest. Prior loan repayments made by the participant would be applied solely to reduce the portion of the loan that didn’t exceed the limit;
  • The participant would make a special supplemental payment equal to the original loan excess amount. Prior loan repayments made by the participant would be applied to pay the interest on the portion of the loan in excess of the limit, with the remainder of the repayments used to reduce the portion of the loan that didn’t exceed the limit; or
  • The original participant loan is treated as two loans; one being the amount in excess of the limit and the second being the amount up to the limit. Prior loan repayments made by the participant would be applied pro rata against both loans. The participant would be required to make a special supplemental corrective payment equal to the amortized remaining balance of the original loan excess.
  • After the participant makes the corrective payment, the participant may reform the loan to amortize the remaining principal balance over the remaining period of the original loan.
  • If the affected participant isn’t willing to make corrective payments or have the loan re-amortized then the plan or plan sponsor may simply report the excess loan amount as a deemed distribution and issue the form 1099-R in the year of correction. In 2009, and later years additional actions may need to be taken to recover the excess loan monies.

Plan loan exceeds the 5-year limit - this mistake is only correctible using VCP or Audit CAP.

  • Correction is to re-amortize the loan balance over the remaining 5-year period that began on the original loan date.
  • If the 5-year limit has expired, the only correction available under VCP or Audit CAP is to make the loan a deemed distribution in the current or prior year.

Plan loan is defaulted because the participant fails to make required payments - this mistake is only correctible using VCP or Audit CAP.

  • The participant must either:
    • Make a lump sum payment for the missed installments (including interest), or
    • Re-amortize the outstanding balance of the loan, including unpaid interest over the remaining life of the original loan term.
      • Balance to be re-amortized must include all missed interest payments.
      • Balance may not exceed the statutory limit of $50,000. The participant may make a lump sum payment to the 403(b) plan to bring the balance to the statutory limit.

    • If the affected participant isn’t willing to make corrective payments or have the loan re-amortized then the plan or plan sponsor may simply report the unpaid loan amount as a deemed distribution and issue the form 1099-R in the year of correction.

When does a plan loan become defaulted?

  • For 2009 or subsequent plan years, if the written plan or program contains language for a “cure period” or if the cure period was part of the annuity contract or custodial account in pre-2009 years:
    • Plan may allow for a “cure period” that permits participants to make up missed payments.
      • This cure period may extend to the end of the calendar quarter following the calendar quarter of the missed payment.
      • Therefore, a participant loan becomes defaulted after the end of the calendar quarter following the calendar quarter of the missed payment.

    • If the plan doesn’t contain language for a “cure period” or if the language was not part of the annuity contract or custodial account in pre-2009 plan years:

  • Participant loan becomes defaulted after the first missed payment.

During the VCP submission process or in Audit CAP, the IRS may require the employer to pay a portion of the correction payment for the participant. The only portion of the correction payment that the employer may pay is the additional interest owed for failure to timely repay the loan. In general, the affected participant is responsible for paying any delinquent loan payments.

Example:
Private University maintains a formal loan program for its 403(b) plan participants. The plan had 2,500 participants as of the end of 2013. Private University is not a governmental entity. Private University conducted an internal review of its loan program and uncovered the following:

  • Bob received a loan from the plan on May 1, 2012. The loan was for $60,000 over a five-year term, amortized monthly using a reasonable interest rate. Bob made the required loan payments on time. The loan amount is less than 50% of Bob’s vested account balance. However, the loan amount exceeds the maximum limit of $50,000.
  • Terri received a loan of $10,000, dated April 1, 2012, over a 6-year period. Payments are timely and the interest rate is reasonable. The term of the loan exceeds the maximum 5-year repayment period.
  • Dean borrowed $10,000, dated March 1, 2012, over a 5-year period. Because of a payroll error, Private University failed to withhold the required loan payments from Dean’s pay since August 1, 2012. The loan amount is less than 50% of Dean’s vested account balance and the interest rate is reasonable.
  • Private University corrected the errors on February 1, 2013.

Corrective action:
Bob – Loan amount in excess of the $50,000 limit - Private University decided to correct this mistake by treating the loan as two loans - loan A for $50,000 and loan B for $10,000. Private University chose this correction method because it provided Bob with the smallest repayment, the amortized remaining balance of the original loan excess. After repayment, the remaining balance of the loan is reamortized over the remaining period of the original loan.

Terri – Loan term in excess of the 5-year limit - Private University is correcting this mistake by re-amortizing the loan balance over the remaining period of the 5-year limit, starting from the original loan date. On February 1, 2013, Private University reamortized the balance of the loan for Terri so that it will be fully repaid by April 1, 2017 (within 5 years of the original loan).

Dean – Loan payments not made - The loan went into default as of November 2, 2012, on the expiration of the plan’s stated cure period of three months. It was determined the employer was partially at fault, because of its failure to continue collecting loan payments. Private University decided to correct the mistake by requiring Dean to make a lump sum repayment equal to the additional interest accrued on the loan and to re-amortize the outstanding balance over the remaining period of the loan.

While the above corrections are consistent with the correction principles Revenue Procedure sections 6.07(2) and (3) that allow for tax-free correction, the IRS will limit its approval of these correction methods to situations that it considers appropriate. The IRS will review the VCP applicant’s submitted explanation to see if it would be appropriate to allow the above correction methods and grant the participants income tax relief from what would normally be associated with a deemed distribution.

Alternatively, Private University can use the VCP process to issue Form 1099-Rs to the affected plan participants for the deemed distributions and request that Private University issue the forms to the participants in the year of correction instead of the year of the failure.

Correction programs available:

Self-Correction Program:
Under Revenue Procedure 2013-12, starting in 2009, SCP is only available to correct a 403(b) plan that allowed for participant plan loans in operation, but didn’t contain language providing for them. This applies to very limited circumstances. For the loans in the examples above, Private University may only make correction under VCP or Audit CAP. See Revenue Procedure 2013-12, section 4.05 and Appendix B section 2.07.

Voluntary Correction Program:
Under VCP, the loan failures could be corrected in a tax-free manner, if Private University requests that the affected participant loans be corrected by developing correction methods based on Revenue Procedure 2013-12 sections 6.07(2) and (3).

Private University submits a VCP submission according to Revenue Procedure 2013-12 and requests that the deemed distribution not be reported on any Form 1099-R and repayments made do not result in the affected participant having additional basis in the plan for determining the tax treatment of subsequent distributions from the plan to the affected participant. Private University would have to provide a detailed explanation supporting this request. The fee for Private University’s VCP submission (based on 2,500 plan participants at the end of 2013) is $15,000. However, Private may qualify for a 50% reduction on the regular compliance fee if the participant loan failures that are to be resolved by the VCP are the sole failure of the submission and the number of affected loans does not exceed 25% of the plan sponsor’s participants in any of the affected years.

Plan sponsors are encouraged to make their VCP submission using the model documents in Appendix C, including Schedule 5 and Forms 8950 and 8951.

Audit Closing Agreement Program:  
Under Audit CAP, correction is the same as described above. Private University and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.

How to avoid the mistake:

It is critical that the 403(b) plan, the plan sponsor and 403(b) vendors associated with the plan have systems in place to ensure that the participant loan terms and the actual repayments comply with all the conditions necessary to keep the loan from being treated as a taxable distribution to the participant. A plan sponsor working with the plan’s 403(b) vendors should develop comprehensive loan procedures, which should include:

  • Plan administrators should determine the maximum loan amount as part of the process for approving a loan request. Make data relating to a participant’s account balance and prior loan history available to the individuals responsible for ensuring that the loan is made within the applicable limit.
  • Have a policy for determining the interest rate for the loans that considers current market factors.
  • Each loan should be a written agreement. Never base a loan on an oral agreement or any informal basis.
  • Document any loans that depart from general rules. For example, each loan that exceeds five years should include materials to verify that the participant is using the loan for the purchase of a primary residence.
  • Develop procedures to monitor the loans for timely repayment. Most plans enforce loan repayment by payroll deduction, increasing the likelihood of timely payments. Work with the payroll department or service provider to develop a system to collect and forward the proper loan payment to the plan. Loan payments must meet the same stringent deposit rules as elective deferrals.
  • Develop procedures for the plan’s record keeper to monitor the receipt of loan payments and allocate the amounts to the appropriate participants’ loan balances.
  • Obtain accurate software (or other aides) used to determine loan limits, repayment amounts, etc.
  • Adopt a cure period to allow time for the plan administrator to resolve any missed installment payments before the loan is considered in default.

403(b) Plan Fix-It Guide
EPCRS Overview
403(b) Plan Fix-It Guide (.pdf)
403(b) Plan Checklist (.pdf)
Additional Resources

IRS.gov / Retirement Plans / Correcting Plan Errors / Fix-It Guides / Potential Mistake

Page Last Reviewed or Updated: 30-Oct-2014