Setting an Interest Rate for Plan Participant Loans

“We sponsor an Employee Retirement Income Security Act (ERISA) 403(b) plan and are in the process of adding a loan feature. Our recordkeeper has asked us to set an interest rate for loans. Is there any guidance as to what interest rate we should set?”

Charles Filips, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, senior financial adviser at CAPTRUST, answer:

Not a whole lot, unfortunately. ERISA and the Internal Revenue Code require that loans bear a “reasonable rate of interest,” but the regulations do not provide a ton of specifics on what rates qualify as reasonable.

Department of Labor (DOL) Reg Section 2550.408b-1 states that “a loan will be considered to bear a reasonable rate of interest if such loan provides the plan with a return commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances.” Thus, under these regulations, a plan sponsor would presumably need to benchmark with banks the interest rate that a participant could obtain with them (and an old Advisory Opinion, 81-12A, suggests that plan sponsors do just that), which would be a cumbersome process.

The IRS has a similar requirement that loans bear a reasonable rate of interest, but, unfortunately, they are short on specifics as well. In a phone forum that took place more than a decade ago, the IRS informally stated that the Prime Rate (currently at 3.25%) plus 2% would be considered to be a reasonable rate for participant loans. Thus, you do so see many plans that would charge an interest rate in the area of 5.25% on current loans. However, other plan sponsors use an alternate method of calculating interest rates, such as the Prime Rate plus 1%, or a rate based on the Moody’s Corporate Bond Yield Average, which, historically, has been lower than the Prime Rate.

Whatever interest rate determination you decide upon (and you should discuss the issue with your outside ERISA counsel), a plan sponsor should be able to justify the reason for the plan loan interest rate selected. Keep in mind that, even though a retirement plan participant repays interest to his/her own retirement plan account—essentially, he/she is paying interest on the loan to him/herself—that interest repaid to the plan is double-taxed, since the participant repays the with after-tax dollars and has zero basis on withdrawal, thus getting taxed again on those funds. Thus, plan sponsors may wish not to err on the high side in setting a reasonable rate of interest, due to the added tax burden.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

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