Magazine

Plan Corrections | Published in September 2016

When a Participant Loan Falls
Through The Cracks

How to fix a default when repayments have been missed

By Karen Wittwer | September 2016
Art by Gurleen Raj

ERROR: A defined contribution (DC) retirement plan sponsor neglects to start making repayments after a participant borrows against his account.
 
CONSEQUENCE: Under Internal Revenue Code (IRC) Section 72(p)(2), a participant who has taken a 401(k) loan must pay it back in level, at least quarterly, installments by their due date. Otherwise, the loan goes into default—the result being the Internal Revenue Service (IRS) will treat it as a deemed distribution, subject to tax.
 
Further, the employee must still make up the missed installments—although that part of his account will not be taxed again, on final distribution. Additionally, the IRS might ask the employer to pay a portion of the tax, if the company’s negligence caused the default.
 
CORRECTION: Some plans allow for a “cure period” as permitted under IRS modifications to Section 72(p). If the one in question does, depending on plan provisions, the participant may have as long as until the end of the calendar quarter following the one in which the first installment was missed to correct the error. If not, the loan is in default from the first missed payment.
 
Either way, the error must be discovered to be fixed. The IRS recommends that retirement plans, at the start of each month, “reconcile the aggregate payroll deposits to the plan (employees’ elective contributions and loan repayments) with the payroll amounts that should have been deposited to the plan. If there are gaps, then payroll records, election forms and loan documents should be analyzed on an individual basis to determine whether the correct amounts—including loan repayments—were withheld from the employees’ paychecks and deposited into the plan.”
 
Once the error is found, if the plan has no provision for a cure period, or if the cure period has elapsed, the plan administrator may seek relief under the IRS Voluntary Correction Program (VCP). The plan administrator may ask the participant to do one of the following, any of which will provide relief—i.e., no tax will need to be paid:

  • Re-amortize the outstanding balance of the loan, resulting in larger installment payments for the remainder of the loan period;
      
  • Make a lump-sum payment covering the missed installments, plus the agreed upon interest, then finish out payments according to the original agreement; or
      
  • Make a partial lump-sum payment for less than the delinquent amount, and re-amortize the outstanding balance of the loan, again over the time remaining. 

PREVENTION: Often, errors of this type occur because the payroll department never was told a loan was made and, consequently, fails to withhold from the participant’s pay. To ensure that loans get repaid as required, the IRS suggests that retirement plans establish a policy whereby payroll must confirm it knows a loan is being made—e.g., an authorized person must initial the approved loan application form—before the plan can write the check. The agency also advises plans to adopt a cure period, as that gives the administrator at least a window of time to correct an error before a loan defaults.

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