401k administrators play many roles—including, often somewhat reluctantly, banker.
In addition to all other duties, plan administrators are responsible for the administration of 401k retirement plan loans. This includes…
Making sure that loans taken from the plan comply with the plan documents and IRS rules
- Setting up repayment withholdings in payroll
- Monitoring loan repayments
- Ensuring that the loan is repaid or properly handled when an employee who has a loan leaves
- If 401k loans are common in your plan, this can be a lot. And chances are you’re already pretty overworked.
We’ll take you through the IRS’s 401k loan rules and regulations to keep you from tripping up.
A Quick Overview of 401k Loans
A 401k loan is one that’s borrowed from a participant’s vested retirement account assets — basically, money they borrow from themselves.
When your employee wants to borrow from their 401k, they’ll request the loan through the recordkeeper’s website. When this happens, you’ll be sent an alert. Depending on the recordkeeper, you may have to review the request and decide whether or not to approve it.
Once the request is approved, the recordkeeper will create a written loan agreement and amortization schedule and will distribute the funds. You will then need to set up the loan repayment withholdings in payroll according to the schedule provided by the recordkeeper.
IRS 401k Loan Rules
Like all things retirement-related 401k loans come with rules (and consequences for breaking them) — courtesy of the Internal Revenue Service.
The rules are set up to give participants access to their funds, while still protecting their retirement savings. As such, the rules revolve around approving loans and setting up payroll to correctly handle the loan repayments.
IRS Rules for 401k Loan Approvals
- Make Sure Your Plan Allows Loans—While the IRS has specific rules for 401k loans, not all plans allow loans. So your first step is to check your plan documents to make sure that loans are even allowed.
- Abide by the Maximum Loan Amount—The maximum amount that can be taken out as a loan is $50,000 OR 50 percent of the participant’s vested account balance, whichever is less.
- Lay It Out in a Loan Agreement—A handshake isn’t gonna cut it. Each 401k loan has to be laid out in a paper or electronic document that details the date and amount of the loan, and binds the participant to a repayment schedule.
- Be Reasonable with Rates and Repayment—The IRS mandates that 401k loans must be secured and that the interest rate and repayment schedule are “commercially reasonable” — i.e no worse than you’d get from a lender on the market.
- Do Things Promptly—This isn’t technically an IRS rule — but it is still important. There can be several different people, departments, or companies to get through before loan approval is finalized, but time is often of the essence. This process can take anywhere from a day to several weeks, but too long may cause employee complaints to the DoL or IRS.
Rules for Payroll and 401k Loans
- Stick to the Repayment Schedule—Each payment should be generally equal amounts, paid at least every quarter, with the loan being fully repaid within five years*.
As the plan administrator, you’re responsible for correctly setting up payment schedules. If a participant changes their repayment rate or makes a payment directly to the recordkeeper, the withholding schedule will have to be adjusted accordingly before you run payroll next.
*Note: The IRS lets you waive the five-year repayment deadline if the loan is used to purchase a primary residence.
- Don’t Cause a Loan to Default—Defaulting on any loan is a bad idea – and a 401k loan is no exception.
As plan administrator, if a participant defaults on their loan because you fail to properly set up repayment withholdings, you’ll be responsible for paying off the remainder of the loan.
If a defaulted loan isn’t taken care of, you could be looking at the ultimate panic moment in 401k administration — potential 401k plan disqualification.
401k loans are quite bit of work as well as a pretty hefty scoop of responsibility. As the administrator for the plan, you’re not only responsible for issuing that loan, you’re signed on for any mistakes that you make during its repayment.
Let’s go over a few of the common ones below…
Common Mistakes With 401k Loans
When it comes to 401k loans, it’s really easy to make a mistake. Here are some of the most common:
- Insufficient Loan Payment—If a loan payment is too small due to an administrative error, your company is responsible for making up the difference.
- Missed Loan Payment—If a participant misses a loan payment because of an administrative error, your company could be on the hook for making the payment on the participant’s behalf.
- Loan Default—If the participant misses enough payments, the loan goes into default. If this happens due to an administrative error, your company could be responsible for paying the remaining loan balance in its entirety.
- Loan Overpayment—If loan repayment withholdings aren’t stopped on time, you’ll have to run a payroll reversal with the recordkeeper and refund the money to the participant.
As in any payroll-related 401k process, mistakes are very common and super easy to make. In our experience, the best way to avoid them is with a complete integration between your payroll and recordkeeping systems. In particular, you’ll want an integration that has checks and balances in place to ensure that loan repayments are set up properly.
Conclusion
Handling 401k loans perfectly is not an easy task. But correcting errors can be costly and time-consuming, so it’s a task well worth pursuing.
If 401k loans seem overwhelming or you simply don’t want to deal with them, not to worry! We’ve helped hundreds of businesses handle 401k loans and other administrative hassles – with minimal effort on their part!
Our all-in-one administration and compliance solution makes 401k loans effortless for you. When a participant requests a loan, when needed, our administration experts review and approve the loan.
Our system then automatically sets up the proper repayment withholdings in payroll, and then continuously runs validations to ensure that the correct payment is being made on time. With our solution, those horrifyingly common 401k loan mistakes won’t trouble you.
Evan Ross, content guru with San Francisco-based 401k tech company ForUsAll, is on a mission to use the power of storytelling to change the world for the better. And what better way to change the world than to help everyday Americans retire with comfort and dignity?
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
