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Under what circumstances can a loan be taken from a qualified plan?
A qualified plan may, but is not required to provide for loans. If a plan provides for loans, the plan may limit the amount that can be taken as a loan. The maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.
For example, if a participant has an account balance of $40,000, the maximum amount that he or she can borrow from the account is $20,000.
A participant may have more than one outstanding loan from the plan at a time. However, any new loan, when added to the outstanding balance of all of the participant’s loans from the plan, cannot be more than the plan maximum amount. In determining the plan maximum amount in that case, the $50,000 is reduced by the difference between the highest outstanding balance of all of the participant’s loans during the 12-month period ending on the day before the new loan and the outstanding balance of the participant’s loans from the plan on the date of the new loan.
For example, assume Participant A has a vested account balance of $100,000 and took a plan loan of $40,000 on January 1, 2005, to be paid in 20 quarterly installments of $2,491. On January 1, 2006, when the outstanding balance is $33,322, Participant A wants to take another plan loan. The difference between the highest outstanding loan balance for the preceding year ($40,000) and the outstanding balance on the day of the loan ($33,322) is $6,678. Since the new loan plus the outstanding loan cannot be more than $43,322 ($50,000 – $6,678), the maximum amount that the new loan can be is $10,000 ($43,322 – $33,322).
A plan may require the spouse of a married participant to consent to a plan loan.
(IRC Section 417(a)(4))
A plan that provides for loans must specify the procedures for applying for a loan and the repayment terms for the loan. Repayment of the loan must occur within 5 years, and payments must be made in substantially equal payments that include principal and interest and that are paid at least quarterly. Loan repayments are not plan contributions.
(Reg. Section 1.72(p)-1, Q&A-3)
A loan that is taken for the purpose of purchasing the employee’s principal residence may be able to be paid back over a period of more than 5 years.
(IRC Section 72(p)(2)(B)(ii); Reg. § 1.72(p)-1, Q&A-5,-6, -7, and -8)
A plan may suspend loan repayments for employees performing military service.
(Reg. Section 1.72(p)-1, Q&A-9(b))
A plan also may suspend loan repayments during a leave of absence of up to one year. However, upon return, the participant must make up the missed payments either by increasing the amount of each monthly payment or by paying a lump sum at the end, so that the term of the loan does not exceed the original 5-year term.
(Reg. Section 1.72(p)-1, Q&A-9(a))
Loans are not dependent upon hardship. Some plans may provide for hardship withdrawals, however. As long as a plan provides for loans, the purpose of the loan or the participant’s ability to borrow the same amount elsewhere is irrelevant in determining whether the loan is permitted, unlike hardship withdrawals, which require a demonstration of need.
The participant’s relationship to the plan (e.g., being an owner of the plan sponsor) does not affect the participant’s ability to take a loan, as long as all participants are equally able to take loans under the plan’s loan provisions.
Loans are not taxable distributions unless they fail to satisfy the plan loan rules of the regulations with respect to amount, duration and repayment terms, as described above. In addition, a loan that is not paid back according to the repayment terms is treated as a distribution from the plan and is taxable as such.
(IRC Section 72(p); Reg. Section 1.72(p)-1, Q&A-1)
If your 401(k) plan or 403(b) plan has made loans that haven’t complied with plan terms about loans, find out how you can correct this mistake.
What happens if a plan loan is not repaid according to its terms?
A loan that is in default is generally treated as a taxable distribution from the plan of the entire outstanding balance of the loan (a “deemed distribution”). The plan’s terms will generally specify how the plan handles a default. A plan may provide that a loan does not become a “deemed distribution” until the end of the calendar quarter following the quarter in which the repayment was missed. For example, if the quarterly payments were due March 31, June 30, September 30 and December 31, and the participant made the March payment but missed the June payment, the loan would be in default as of the end of June, and the loan would be treated as a distribution at the end of September.
(Reg. Section 1.72(p)-1, Q&A-10(a))
If your 401(k) plan or 403(b) plan has made loans that haven’t complied with plan terms about loans, find out how you can correct this mistake.
Is a deemed distribution treated like an actual distribution for all purposes?
No, a deemed distribution is treated as an actual distribution for purposes of determining the tax on the distribution, including any early distribution tax. A deemed distribution is not treated as an actual distribution for purposes of determining whether a plan satisfies the restrictions on in-service distributions applicable to certain plans. In addition, a deemed distribution is not eligible to be rolled over into an eligible retirement plan.
(Reg. § 1.72(p)-1, Q&A-11 and -12)
Can a loan be taken from an IRA?
Loans are not permitted from IRAs or from IRA-based plans such as SEPs, SARSEPs and SIMPLE IRA plans. Loans are only possible from qualified plans that satisfy the requirements of 401(a), from annuity plans that satisfy the requirements of 403(a) or 403(b), and from governmental plans. (IRC Section 72(p)(4); Reg. Section 1.72(p)-1, Q&A-2)
What happens if a loan is taken from an IRA?
If the owner of an IRA borrows from the IRA, the IRA is no longer an IRA, and the value of the entire IRA is included in the owner’s income. (IRC Sections 408(e)(2) and (3)). If the owner of an IRA pledges part of the IRA as collateral, the part of the IRA that is pledged is treated as distributed. (IRC Section 408(e)(4))
What is a partner’s “compensation” for retirement plan purposes?
A partnership makes annual contributions to a partner’s retirement plan account based on her net earned income.
Net earned income
For a partner, this is calculated in the same way as for most other self-employed plan participants by starting with the partner’s earned income and then subtracting:
plan contributions for the partner, and
half of her self-employment tax.
IRS Publication 560 has tables and worksheets to calculate the deduction for contributions to a qualified plan for a partner.
Partner’s earned income
A partner’s earned income is the income she receives for her services to materially help produce that income (see Internal Revenue Code sections1402 and 401(c)(2).) A partner must separately calculate her earned income for each trade or business.
Not every partner may have earned income (for example, a limited partner who does not provide services to the partnership and is merely an investor). Also, all of a partner’s income from the partnership may not be earned income (for example, investment income that is passed through the partnership to the partners).
Why is the IRS holding-up my money from my retirement plan now that the plan has terminated?
When a plan has formally terminated and submitted a Form 5310, Application for Determination for Terminating Plan, the IRS will review the application in an expedient manner. However, on many occasions there are questions raised which need to be addressed before a favorable letter is issued. Also, the employer or trustee is not required to hold the assets until a favorable determination letter is issued, but usually will do so as a safety feature to ensure that distributions will receive the favorable tax treatment to which qualified plan distributions are entitled.
NOTE: The IRS does not maintain or hold the assets during the termination process.
When are assets required to be distributed after a plan has terminated?
Generally, an employer is required to distribute assets from a terminated plan as soon as it is administratively feasible after the date of plan termination.
Whether distributions are made as soon as it is administratively feasible is determined under all the facts and circumstances of a given case, but generally the Internal Revenue Service views this to mean within one year after plan termination (see Rev. Rul. 89-87, 1989-2, C.B. 81).
Are there special limits on the type of investments available to retirement plans?
Although there is no list of approved investments for retirement plans, there are special rules contained in the Employee Retirement Income Security Act of 1974 (ERISA) that apply to retirement plan investments. In general, a plan sponsor or plan administrator of a qualified plan who acts in a fiduciary capacity is required, in investing plan assets, to exercise the judgment that a prudent investor would use in investing for his or her own retirement. (ERISA § 404) In addition, certain rules apply to specific plan types. For example, there are different limits on the amount of employer stock and employer real property that a qualified plan can hold, depending on whether the plan is a defined benefit plan, a 401(k) plan, or another kind of qualified plan. (ERISA §407) Certain plans, such as 401(k) plans, that permit participant-directed investment can avoid some fiduciary responsibilities if participants are offered at least three diversified options for investment, each with different risk/return factors. (Labor Reg. Section 2550.404c-1)
In addition, under the Code, both participant-directed accounts and IRAs cannot invest in collectibles, such as art, antiques, gems, coins, or alcoholic beverages, and they can invest in certain precious metals only if they meet specific requirements. (IRC Section 408(m))
Individual retirement accounts also are not permitted to invest in life insurance. (IRC Section 408(a)(3))
Finally, certain transactions between a plan and a “disqualified person” are specifically prohibited by law (see below). Similar rules apply to transactions between an IRA and its owner or beneficiary or between an IRA and a disqualified person.
What is a prohibited transaction?
A prohibited transaction is a transaction between a plan and a disqualified person that is prohibited by law.
Prohibited transactions generally include the following transactions:
a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
any act of a fiduciary by which plan income or assets are used for his or her own interest;
the receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets;
the sale, exchange, or lease of property between a plan and a disqualified person;
lending money or extending credit between a plan and a disqualified person; and
furnishing goods, services, or facilities between a plan and a disqualified person.
Certain transactions are exempt from being treated as prohibited transactions. For example, a prohibited transaction does not take place if a disqualified person receives a benefit to which he or she is entitled as a plan participant or beneficiary. However, the benefit must be figured and paid under the same terms as for all other participants and beneficiaries.
The Department of Labor (DOL) has granted class exemptions for certain types of investments under conditions that protect the safety and security of the plan assets. In addition, a plan sponsor may apply to the DOL to obtain an administrative exemption for a particular proposed transaction that would otherwise be a prohibited transaction.
For additional information, see IRS Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).
Who is a disqualified person for purposes of the prohibited transaction rules?
A qualified person is any of the following:
(1) a fiduciary of the plan;
(2) a person providing services to the plan;
(3) an employer, any of whose employees are covered by the plan;
(4) an employee organization, any of whose members are covered by the plan;
(5) any direct or indirect owner of 50% or more of any of the following:
the combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4);
the capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4); or
the beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4);
(6) a member of the family of any individual described in (1), (2), (3), or
(4) (i.e., the individual’s spouse, ancestor, lineal descendant, or any
spouse of a lineal descendant);
(7) a corporation, partnership, trust, or estate of which (or in which) any
direct or indirect owner described in (1) through (5) holds 50% or more of any of the following:
the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation;
the capital interest or profits interest of a partnership; or the beneficial interest of a trust or estate;
(8) an officer, director (or an individual having powers or responsibilities
similar to those of officers or directors), a 10% or more shareholder, or highly compensated employee (earning 10% or more of the yearly
wages of an employer) of a person described in (3), (4), (5), or (7);
(9) a 10% or more (in capital or profits) partner or joint venture of a person described in (3), (4), (5), or (7); or
(10) any disqualified person, as described in (1) through (9) above, who
is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under section 4223 of ERISA.
What are the consequences of participating in a prohibited transaction?
A disqualified person who takes part in a prohibited transaction must correct the transaction and must pay an excise tax based on the amount involved in the transaction. The initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed. Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.
The amount involved in a prohibited transaction is the greater of the following amounts:
The money and fair market value of any property given; and
The money and fair market value of any property received.
If services are performed, the amount involved is any excess compensation given or received.
The taxable period starts on the transaction date and ends on the earliest of the following days:
The day the IRS mails a notice of deficiency for the tax;
the day the IRS assesses the tax; and
the day the correction of the transaction is completed.
The tax is paid with Form 5330.
How is a prohibited transaction corrected?
A disqualified person who participated in a prohibited transaction can avoid the 100% tax by correcting the transaction as soon as possible. Correcting the transaction means undoing it as much as possible without putting the plan in a worse financial position than if the disqualified person had acted under the highest fiduciary standards.
If the prohibited transaction is not corrected during the taxable period, the disqualified person usually has an additional 90 days after the day the IRS mails a notice of deficiency for the 100% tax to correct the transaction. This correction period (the taxable period plus the 90 days) can be extended if either of the following occurs:
the IRS grants reasonable time needed to correct the transaction; or
the disqualified person petitions the Tax Court.
If the transaction is corrected within this period, the IRS will abate, credit, or refund the 100% tax.
For additional information, see Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).
How do the prohibited transaction rules apply to IRAs?
A prohibited transaction with respect to an IRA occurs if the owner or beneficiary of the IRA engages in certain transactions. However, in this case, with an individual retirement account, instead of imposing an excise tax on the parties to the transaction, the Code provides that the account is no longer an individual retirement account, and it is treated as if the assets were distributed on the first day of the taxable year in which the prohibited transaction occurred. (IRC Section 408(e)(2))
A prohibited transaction can also occur between an IRA and a disqualified person other than the IRA owner or beneficiary, such as a relative of the owner or beneficiary or a fiduciary. If a prohibited transaction with respect to an IRA involves a disqualified person other than the IRA owner or beneficiary, then that other person is subject to the prohibited transactions excise tax.