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 of excess loan amounts or modification of loan terms, if you make a submission under the Voluntary Correction Program or via Audit CAP. 

 

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

 

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 enforcing loan repayments. “Hold harmless” agreements between a 403(b) plan sponsor and its vendors do not lessen the plan sponsor’s responsibility.  

Participant loans must meet several 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 that include principal and interest, at least quarterly, over the life of the loan. (There are exceptions for a leave of absence or military service.)
    • Exception for leave of absence:
      • Repayments may be suspended for up to one year while the participant is on a leave of absence.
      • The loan’s maximum repayment period is not extended.
      • On return from leave of absence, the participant must make additional payments to ensure repayment within the 5-year period by either:
        • Increasing the payments over the rest of the loan term, or
        • Keeping the payments the same, but making a catch-up payment for the missed payments during the leave of absence. 

Note:  A plan may suspend loan payments for more than one year for an employee performing military service.  In this case, the employee must repay the loan within 5 years from the date of the loan, plus the period of 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. It’s more likely you’ll have errors if you’re trying to coordinate several vendors. 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?
      • Does the participant have more than one loan outstanding? If so, the outstanding balance needs to be taken into consideration in determining if the $50,000 loan limit has been exceeded. 
    • 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 of principal and interest 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 a cure period, one missed payment could put the loan into default.
        • If the plan provides 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 5 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 on 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 sure 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 2021-30 Appendix B Section 2.07(3).

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 reamortized, 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 amounts.

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 correctible using SCP, 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 reamortized, 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, then the 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 total current value of annuity contracts and custodial accounts associated with the plan is over ten million dollars. The plan had 2,500 participants as of the end of 2019. 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, 2018. The loan was for $60,000 over a 5-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, 2018, 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, 2018, 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, 2018. 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, 2020.

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. Because Bob has already repaid some of the loan, these repaid amounts may be considered in determining the amount of the required corrective payment.  Private University applied Bob’s prior repayments on a pro-rata basis between the $10,000 loan excess and the $50,000 maximum loan amount.  Private University chose this correction method because it provided Bob with the smallest repayment.  Bob’s corrective payment is the balance remaining on the $10,000 loan excess as of February 1, 2020 (the date of correction).  After repayment of the excess amount, 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, 2020, Private University reamortized the balance of the loan for Terri so that it will be fully repaid by April 1, 2023 (within 5 years of the original loan).

Dean – Loan payments not made - The loan went into default as of November 2, 2018, on the expiration of the plan’s stated cure period of three months, which is less than the cure period allowed by statute. 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 principles of Revenue Procedure 2021-30 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 submitted explanation included in the VCP submission 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 Forms 1099-R 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 (2020) instead of the year of the failure (2018).

Correction programs available:

Self-Correction Program:

Beginning April 19, 2019, some mistakes discovered or corrected on or after this date, involving IRC 72(p) can be addressed in SCP if certain conditions can be met.  Otherwise, the Voluntary Correction Program (VCP) may be available if the plan is not under IRS examination.

Failure Correction under SCP Conditions
1. Loan does not meet the exceptions of IRC 72(p)(2) or is in default that is not corrected under section 6.07(3). See Rev. Proc. 2021-30, sections 6.07(1), and 6.07(2)
  • Report deemed distribution in the year of correction instead of the year of the failure
  • Follow IRS Regs. 1.72(p)‑1 in terms of reporting the deemed distribution amount on Form 1099-R
  • If withholding applies under IRS Regs. 1.72(p)‑1 (Q&A 15), it must be paid by the plan sponsor
2. Defaulted loans. See Rev. Proc. 2021-30, section 6.02(6) and section 6.07(3)(d)
  • Participant makes a single lump sum payment that includes all missed payments, including accrued interest; or
  • The outstanding balance of the loan, including accrued interest is reamortized over the remaining period of the loan so that the unpaid principal and accrued interest is repaid by the end of original term of the loan or by the end of the maximum period under IRC 72(p)(2)(B), measured from the original date of the loan
  • The correction methods in the first two bullets, above, can be combined
  • This correction method is not available if the maximum period for repayment of the loan pursuant to IRC 72(p)(2)(B) has expired
  • IRS reserves the right to limit the use of this correction method to situations that it considers appropriate
  • The participant must be willing to take actions to fix the defaulted loan
  • Avoids deemed distribution
  • No need to issue a Form 1099-R
  • The employer should make a corrective contribution to the participant's account if the plan's rate of return exceeded the plan loan interest rate

Special relief from the deemed distribution rules of IRC 72(p) is not available under SCP if the plan loan doesn’t comply with IRC 72(p)(2)(A), IRC 72(p)(2)(B), or IRC 72(p)(2)(C) and may only be obtained via VCP or, if under IRS audit, Audit CAP.

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 2021-30 sections 6.07(2) and (3).

Private University makes a VCP submission in 2020 according to section 11 of Revenue Procedure 2021-30 using the Pay.gov website. User fees for the VCP submission are generally based on the amount of 403(b) plan assets.  

As part of the VCP submission, Private University requests that there be no deemed distribution and no additional basis in the plan for determining subsequent distributions to the affected participant. Private University would have to provide a detailed explanation supporting this request. 

Plan sponsors are encouraged to make their VCP submission using Form 14568, Model VCP Compliance Statement and Form 14568-E, Model VCP Compliance Statement - Schedule 5: Plan Loan Failures (Qualified Plans and 403(b) Plans).

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 that is not excessive and  considers facts and circumstances, based upon all relevant factors described in section 14 of Rev. Proc. 2021-30.

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. As part of these procedures, a plan sponsor 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.
  • Ensure each loan is 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 5 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.
  • Consider adopting a cure period to allow time for the plan administrator to resolve any missed installment payments before the loan defaults.

Correcting Plan Errors
403(b) Plan Fix-It Guide
EPCRS Overview
403(b) Plan Checklist
Additional Resources

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