Now that employees are no longer allowed to self-certify their eligibility for loans and hardship withdrawals, plan sponsors and administrators have more control in making sure these transactions comply with IRS rules, but any mess made in the traditional environment needs to be cleaned up. For plans with multiple active vendors, or inactive vendors that are either a) part of an ERISA plan, or b) not eligible for grandfathering, and thus part of a non-ERISA plan, try tackling the following administrative challenges.
Attempt to obtain (or arrange for your TPA or other contracted third party to obtain) a list of all participants who have defaulted on loans for all vendors that are a part of your plan. Compare to a list of participants from all vendors who currently have a loan outstanding. If your plan does not permit payroll deduction for loans, any participants who are common to both lists are now official plan defects, as any participant who defaults on a loan is prohibited from borrowing again unless the loan is a) deducted from payroll or b) secured by outside collateral (and it is rare that vendors will accept outside collateral for a loan in my experience).
And, heaven forbid, if you currently sponsor (or have sponsored in the past) more than one plan (e.g., a 401(k), a 457(b) governmental plan. and a 403(b)) you’ll need to obtain lists of loan defaults from those plans as well, since the loan regulations encompass ALL plans of the sponsoring employer. Sound like fun so far? It becomes even more humorous when one learns of the potential consequences of noncompliance: IMMEDIATE TAXATION of the entire outstanding balance of any ineligible loans!
Fortunately there are correction programs, but you can’t correct a defect if you don’t know what to correct, so start assembling those lists now! Furthermore, you’ll need to install procedures in place so that no new loan is taken without first determining whether the participant has defaulted on a prior loan.
Violations of the Loan Limits
Obtain loan reports from all of your vendors who allow loans listing the highest outstanding loan balances over the last 12 months. This is easier said than done, since obviously the highest outstanding loan balance over the prior 12 months at each vendor where a loan exists will change frequently due to loan repayments. Add up all of these figures for each participant. If any individual participant figure amounts to greater than $50,000, you have a problem; namely, a violation of the limitation on the amount a participant may borrow for the individual(s) in question. Similar to the default rules, the loan limits encompass ALL plans of the sponsoring employer so make certain to include any other retirement plans that permit loans (or inactive plans that permitted loans where account balances remain) in your analysis.
Fortunately, due to the other restriction on the amount that may be borrowed (50% of total vested account balances with all plans/vendors of the employer for ERISA plans; or the greater of $10,000 or 50% of the total vested account balances for non-ERISA plans minus the highest outstanding loan balance in the previous 12 month period), loan amounts tend to be smaller than $50,000 in the aggregate for each participant. However, most audits I have undertaken in this regard have revealed at least one participant who has violated this restriction.
The penalty for noncompliance here is less severe than an ineligible loan, resulting in IMMEDIATE TAXATION of only the amount in excess of the loan limit, as opposed to the entire loan amount (Thank you, o’ kind and merciful IRS!). However, if you’ve ever attempted to explain to a participant in this situation the consequences of their actions, it is easy to see why such a defect should be avoided in the first place if at all possible.
Hardship Distributions and Coordination with Loan Eligibility
Assuming that your plan (or annuity contract(s)/custodial agreement(s) if a plan is not yet in place) permits hardship distributions and utilizes a so-called "safe harbor" definition of hardship (most do), the greatest compliance challenge of all may await you (or your TPA/vendor/other third party). While many are aware of some of the administrative challenges associated with the safe harbor hardship regulations (e.g. the required six-month suspension of elective deferrals), there is a lesser-known provision of the rules that requires that "ALL taxable loans from ALL plans maintained by the employer" be obtained BEFORE a valid hardship distribution may be taken. If the total amount available from loans equals or exceeds the hardship amount, no distribution is permitted.
One possible exception to this rule; there is language in the hardship regulations that permits the hardship distribution to be taken if taking the loan would constitute a hardship for the employee (e.g. due to the repayments). However, in actual practice, this circumstance can often to be difficult to determine, and it is not a provision a plan sponsor may wish to rely on in the event of an audit as an excuse for not researching the vendor records for loan availability. Even worse, the penalty for an ineligible hardship distribution can be even more severe than the penalties for the loan defects described above, resulting in potential IMMEDIATE TAXATION of a participant's ENTIRE ACCOUNT BALANCE.
Though this is by no means an exhaustive list of potential "trouble spots," I believe that it should provide plan sponsors and practitioners with a feel for the vast scope of data necessary to administer loans and hardships, especially of a large number of vendors are involved. Plan sponsors may wish to check the utilization of loans, and especially hardship distributions, within their plan. If utilization is low, it may be prudent to eliminate such provisions entirely, since the employee relations impact will be relatively low (although in these troubled economic times, the impact may, in fact, be greater than employers want to encounter).
However, the employer may not be able to prohibit loans for certain de-selected vendors when the underlying contractual language of the annuity contracts or custodial accounts does, in fact, permit loans and does not contain language such as "if the plan permits."
Many TPAs, vendors, and other third parties are offering to serve as the "data aggregator" for all vendors, essentially obtaining all of the indicative data from the multiple vendors/plans and combining it into one database which can then be used to confirm the validity of loans, hardship distributions and other plan transactions. Some entities have even promised seamless automated administration of such transactions, similar to the outsourcing of other common transactions such as investment changes.
This undertaking is not simple due to the vastness of the data required, and some vendors can't (or won't) provide the data necessary for compliance. If only one of a plan sponsor's multiple vendors fails to provide data, essentially the entire compliance operation is undermined. It might be a good idea to condition continued vendor participation in the program on its ability to provide the data necessary to administer loans, hardships, and other transactions. However, since the ability to "grandfather" a vendor expired 1/1/09, plan sponsors will remain responsible for the compliance of existing plan balances even if a vendor is no longer active (note that plan sponsors were ALWAYS responsible for inactive contracts in ERISA plans).
If a plan sponsor decides it needs to hire a third party to provide an effective outsourced solution for such transactional data mining and administration, candidates should be quizzed on the exact situations described in this article. Those who recognize the challenges posed, and do not "promise the moon" but instead attempt to offer specific, practical solutions to the challenges, are worth consideration.
Michael Webb , CRS, CEBS, AIF™, is Vice President, Retirement Services, at Cammack LaRhette Consulting
Cammack LaRhette Consulting (www.clcinc.com) is a full-service employee benefits and human resources consulting firm, offering large and mid-sized businesses and organizations consulting services for Retirement Plans, Health & Welfare Plans, Human Resources, and Human Resources Technology Services.
Please note that this article is for general informational purposes only, is not intended to be taken as legal advice or a recommended course of action in any given situation. Readers should consult their own legal adviser before taking any actions suggested in this article.
« Bill Would Extend COBRA's Hand