April 2013 Newsletter

When Good Loans Go Bad

The economic environment of the last few years created financial challenges  for individuals and businesses alike. Even though the worst of the recession  appears to be behind us now, some of those financial challenges have had a  ripple effect that continues to show itself. One area where that is especially  true relates to the loans participants took from their 401(k) plans. Economic  pressures certainly brought about an increase in loans, but it also caused some  participants with loans to have trouble repaying them.

Background

A quick review of the rules that govern qualified plan loans may help to  provide some context. The Employee Retirement Income Security Act (ERISA)  prohibits plans from loaning money to related parties, including participants,  unless certain requirements are satisfied. The Tax Code also has its own rules  that parallel and supplement those found in ERISA. In other words, loans start  bad and must be made good.

Here is a quick overview of some of the key requirements for making a bad  loan good.

• Amount: The maximum loan a participant can take is 50% of his or her   vested account balance up to $50,000 (reduced by the highest outstanding loan balance in the immediately preceding 12-month period).
• Duration: A participant loan cannot be amortized for more than five years.   There is an exception, however. If the participant will use the loan to   purchase his or her primary residence, the plan can allow the loan to be amortized for longer than five years.
• Payments: Loans must have a level amortization with payments of principal and interest made at least quarterly.
• Interest: Loans must use an interest rate that is reasonable in light of   what a commercial lender would charge for a similar loan.
• Enforcement: A participant loan must be an enforceable agreement under state law. This translates into a requirement that the loan be in writing.
• Documentation: The plan document must specifically authorize participant loans. It must also include (either within the document or through a separate written policy) the above parameters and require that all loans remain within   those parameters.

The above rules are “bookends” of sorts. A company may choose to further  limit its loan provisions but it cannot go outside of the bookends. For example,  many plans limit a participant to only one loan at a time or establish a minimum  loan amount of $1,000. Another common provision is to require loans to be  amortized according to the company’s payroll schedule and payments to be through  payroll deduction. A plan that chooses to impose restrictions must follow those  limitations even if the bookends would allow more liberal treatment.

In order for a bad loan to go good, it must satisfy all of these rules.

Going to the Dark Side

Just as bad loans can be made good, good loans can go bad if, at any time  during their duration, they fail to satisfy any one of the rules…no matter how  insignificant or well-intentioned the oversight might seem. This can lead to  taxes, penalties and administrative burdens for both the plan and the  participant.

Before delving into some of the ways loans can go bad, let’s define a few terms.

Default

When a participant misses a regularly scheduled loan payment, the loan goes  into default. This is almost like loan purgatory; some sort of correction is  required but the loan has not yet reached the point of no return.

Cure Period

The loan regulations provide for a “cure period” for making up a missed loan  payment. It extends through the end of the calendar quarter following the  quarter in which the default occurs. In other words, once a participant misses  one or more payments, he or she has until the end of the following quarter to  make up the shortfall along with accrued interest to cure the default and  prevent a deemed distribution.

Deemed Distribution

This is when some or all of the outstanding balance of a loan is treated as a  taxable distribution to the participant. This can occur either when a defaulted  loan is not cured by the end of the cure period or when a loan is otherwise  defective in some way.

There are two aspects of deemed distributions that are often overlooked.

• There is no action required to trigger the tax liability. Just like a   person’s paycheck is subject to income tax regardless of whether they get a W-2 at the end of the year, a deemed distributed loan is taxable even if no one takes steps to report it on a Form 1099-R. If the participant does not report the amount in question on his or her income tax return, it could generate additional penalties and interest for underpayment of income tax.
• A deemed distribution does not extinguish the participant’s obligation to  repay the loan. In other words, a deemed distributed loan is taxable (and may include a 10% early withdrawal penalty), but the participant must still repay it. To make matters worse, those post-deemed-distribution loan payments create tax basis in the plan and must be tracked as a separate money source on the recordkeeping system.

Offset

A deemed distributed loan continues to be included as a plan asset until the  participant in question has a distributable event, usually termination of  employment. At that time, the outstanding balance is offset and reported on the  plan’s financial statements as an actual distribution.

Examples of Good Loans Gone Bad

Now that we have reviewed the rules and defined some key terms, it is time to  review some of the more common situations that can cause a good loan to go bad.

Loans Not Permitted

Plans are not required to offer loans but those that wish to allow loans must  be sure the appropriate provisions are included in the plan document and/or  separate written loan policy. Plan sponsors may believe they are helping a  participant in need of cash by approving a loan request without going to the  formality of amending the plan document; however, issuing a loan when the plan  does not allow it results in a loan that never becomes good. The full amount of  the loan is immediately deemed distributed.

Generally, a plan can offer loans at any point during the year as long as an  amendment is adopted by the end of that year to add the necessary language to  the plan document. However, once the year closes, there are fewer options for  correction.

Refinancing Not Permitted

When homeowners wish to change their mortgage to get a lower interest rate or  borrow additional money, they do so by refinancing their mortgage. Participant  loans operate the same way. In order to change the terms of a loan, the  participant must refinance it. The trick is that not all plans permit  refinancing. Furthermore, inability to refinance is not always crystal clear.  Consider a plan that permits loans but restricts participants to only one loan  at a time. IRS regulations (and the U.S. Tax Court) look at certain refinancing  transactions as consisting of two loans–the replacement loan (the new one) and  the replaced loan (the old one). Therefore, the refinance transaction violates  the one loan at a time limit, and the replacement loan is a deemed distribution.  This can be addressed by amending the loan provisions to specifically permit  refinancing or to allow multiple loans.

Loan Term Too Long

If a loan is amortized for longer than permitted, it is defective from the  moment it is issued and the entire amount is a deemed distribution. A common  example of this is when a plan issues a general purpose loan for longer than  five years. Since that is a regulatory limit, this type of defect cannot be  remedied by amending the plan to allow a longer amortization.

On the other hand, if a particular plan elects to limit all loans to only  five years but issues a residential loan with a longer amortization period, it  may be possible to amend the plan within the time frame described above.

Payments Never Started

Sometimes a participant takes a loan that is to be repaid by payroll  deduction, but the payroll system does not get set up to begin withholding  payments. Although there is some latitude, payments should begin within one or  two pay periods following issuance of the loan. If that does not occur, the loan  goes into default. Unlike the previous examples, this does not cause the entire  loan to be defective. Rather, the participant has until the end of the cure  period to get principal and accrued interest payments up to date and avoid a deemed distribution.

Payments Voluntarily Suspended or Discontinued

In other circumstances, a participant with a loan determines that he or she  can no longer afford to make payments and asks the company to stop withholding  on a temporary or permanent basis. Some employers may be inclined to help an  employee in that situation by agreeing to the request. Unfortunately, doing so  causes the loan to default (and maybe become a deemed distribution), and it also  subjects plan fiduciaries to liability for breaching their responsibility.

Even though the participant is borrowing from his or her own account balance,  the loan is still considered an asset of the plan. By voluntarily discontinuing  the withholding of payments, the plan sponsor fails to enforce a legal agreement  between the plan and the participant and allows a plan asset to decrease in  value.

Coming Back to the Light

Fortunately, many loans that have crossed over can be brought back to the  light. The IRS Employee Plans Compliance Resolution System (EPCRS) includes a  series of voluntary correction mechanisms, including several for participant  loans. Generally, defective loans are corrected by reforming them so that they  comply with the applicable rules. Depending on the circumstances, other  correction options may also be available. This could include retroactively  amending a plan (effective in a previous year) to permit a loan that was issued  in error.

Unlike other types of oversights, EPCRS does not permit self-correction. In  other words, bringing a bad loan back from the dark side requires submitting  documentation of the correction to the IRS for their approval.

Conclusion

As you can see, the participant loan rules can be challenging even in good  economic times. With all of the potential missteps that can occur, it is important to work with knowledgeable service providers that have strong checks  and balances designed to properly administer participant loans. By also  implementing similar controls internally, plan sponsors can make sure that good  loans don’t go bad.

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February 2013 Newsletter

Don’t Let Missing Participants and Small Balances Become a Big Problem

At some point, almost every company that sponsors a retirement plan will experience the “fun” of tracking down a missing participant in order to pay a benefit. Although difficult to avoid completely, there are steps employers can implement as part of normal operations that can greatly minimize the headache. One of the most effective steps is to distribute benefits to former employees as soon as possible after termination of employment, before they have an opportunity to become missing.

Forcing Distribution of Small Balances

The IRS has rules in place that dictate when terminated participants can/must take distributions of their account balances from defined contribution plans. Embedded within those rules are certain options that can facilitate the efficient payout of smaller balances to many former employees.

Generally, participants who have vested account balances in the plan of at least $5,000 are permitted to keep their money in the plan as long as they wish, subject to required minimum distributions on attainment of age 70½. Participants with balances below that threshold can be forced to take their money out of the plan as long as they are given appropriate notice 30 to 60 days prior to the payment. The notification gives participants the option to rollover their accounts into an IRA of their choice or to a new employer’s plan rather than receiving the payment in cash and incurring a tax liability.

If the participant does not make such an election by the end of the notice period, the employer automatically distributes cash and withholds the appropriate taxes for balances below $1,000. For balances between $1,000 and $5,000, the force-out is via an automatic rollover to an IRA established on behalf of the participant.

When the mandatory distribution rules first took effect in 2005, there were not many automatic IRA rollover options available in the marketplace. As a result, many employers elected to reduce the cash-out threshold to $1,000. Amounts below that level could be forced out via check with taxes withheld but larger amounts could remain in the plan. Fast forward to the present and there are numerous options for automatic IRA rollovers for participants who do not respond to the notice. However, many plans still provide for the lower cash-out limit. A plan amendment can increase the limit to the maximum of $5,000 thereby allowing for the almost immediate payout to a greater number of former employees.

If a terminated participant has a vested balance of less than $200, his or her account can be forced out via a cash payment without having to go through the notification process.

What if the Participant’s Account Balance includes Rollovers?

Consider a participant who joins his or her company’s 401(k) plan and     accumulates an account balance of only $1,500 before terminating employment. However, the participant rolled $7,000 into the plan from a previous     employer’s plan. That makes a total vested balance of $8,500 which is well     above the maximum allowable cash-out limit.

In recognition of this potential conundrum, the IRS created an option that allows plans using the $5,000 cash-out limit to disregard unrelated rollovers into the plan when determining whether or not a former employee can be forced out. Plans with lower cash-out limits are not allowed to take advantage of this rollover exclusion.

Check the Plan Document

Keep in mind that usually when the law provides options on how to handle a certain situation, each plan document must specify which option will be used for that particular plan. As a result, it is always important to check the terms of the plan to make sure it contains the proper language authorizing the preferred option. If not, it is often very straightforward to amend the plan to elect a different option.

What about Larger Balances?

Participants with (non-rollover) vested balances exceeding $5,000 cannot be forced out of the plan; however, there are steps employers can take to     encourage former participants to take distributions of their larger balances. Sometimes simply including plan distribution forms along with other termination paperwork on an employee’s last day of work is enough of a     reminder to them to request payment. In addition, it is permissible to charge regular plan fees to the accounts of former employees even if the company pays the same expenses for active employees.

What if the Plan is Terminated?

Suppose that an employer decides to terminate its plan. The plan cannot be completely wrapped up until all assets are distributed. Although the cash-out rules described above provide a solution for smaller balances, they do not typically apply to larger balances.

Fortunately, the Department of Labor has provided a solution for plans that are completely terminating. In short, sponsors of terminating plans can     automatically rollover vested balances exceeding $5,000 as long as they first take the following four steps to locate missing participants:

Certified Mail: Use certified mail to send out the required distribution paperwork, special tax notice, etc.

Related Plan Records: Check other plan records as well as records for other company benefits such as health insurance plans.

Designated Plan Beneficiary: Check with the participant’s designated beneficiary to see if he or she can provide contact information that may help locate the missing individual.

Letter Forwarding: Use the Social Security Administration (SSA) letter-forwarding service to notify the former participant of the impending plan termination and provide the distribution paperwork. Both the IRS and SSA had letter-forwarding services; however, the IRS discontinued its service during 2012. The SSA service remains active but there is one key difference. The IRS program was free for requests involving fewer than 50 letters, whereas the SSA charges $35 per letter forwarded.

Plan sponsors should also consider using a commercial locator service or a credit reporting agency. Fortunately, the reasonable fees for all of these steps can be charged to the accounts of the missing participants being located.

What about Residual Balances?

From time to time, a former participant may receive a full distribution only to have a residual amount hit his or her account. This may be due to a the participant being eligible for an employer contribution that is not deposited until after the close of the year. A safe harbor nonelective contribution is one example. Sometimes, the residual amount is due to investment earnings that are not posted to the account until after the distribution is taken. Regardless of the source, any trailing amounts must be handled.

As long as the paperwork for the original distribution was signed or the small balance forced out within 180 days, the residual can be processed using the same instructions. For example, if the participant’s original paperwork requested a rollover to an IRA at a certain financial institution and that paperwork was signed within 180 days, the residual distribution can be rolled to that same IRA at the same financial institution without the need for additional paperwork.

If more than 180 days has passed, the residual account balance is handled as if no previous distribution has occurred. In other words, residuals below the cash-out threshold are processed the same as any other small balance requiring notification before forcing out the amount in question. If the residual exceeds the cash-out limit, the participant has the option to keep the money in the plan.

What Happens when a Participant Does Not Cash a Distribution Check?

An uncashed check is one that has not been returned (and was, therefore,     presumably received by the participant) but also has not been negotiated.     Dealing with these checks can be especially challenging and there is no direct guidance on how to handle such situations.

Even if not cashed, the check proceeds are considered taxable income to the participant and should be reported as such on Form 1099-R for the year the distribution was issued. However, the dollars representing those proceeds remain in the plan until the check is physically cashed. As a result, plan fiduciaries remain responsible to prudently manage those assets.

Many plans include provisions that allow such amounts to be forfeited. If the participant comes forward in the future, the plan must make him or her whole by reinstating the forfeited amount and paying the distribution.

A few years ago, it became popular practice to simply pay the entire amount of the distribution to the IRS as income tax withholding. Although very clean and efficient from the plan sponsor’s perspective, the IRS issued guidance indicating such practice was not acceptable. Therefore, sponsors should no longer pursue 100% withholding as an option.

What Happens when the Distribution Fee Exceeds the Account Balance?

It is not uncommon for an employee to be eligible for a plan or to decide to make deferrals for a very short period prior to terminating employment, sometimes only a single pay period. In those situations, the participant’s vested account balance is usually a minimal amount; so minimal, in fact, that the fee charged to process the distribution is greater than the balance. The plan can adopt procedures that automatically charge the fee against such accounts even though no actual distribution is paid.

For example, assume a plan’s recordkeeper charges a fee of $85 to process     each distribution. The plan’s administrative policy could provide that the fee will automatically be charged to the accounts of all terminated participant with vested balances below $85. The amounts charged are paid to the recordkeeper as a fee and the accounts are eliminated.

Plan sponsors that choose to use this type of procedure should work with their advisors and consultants to make sure the decision is properly documented and communicated to employees.

Summary

As the saying goes, an ounce of prevention is worth a pound of cure. In the case of small balances and missing participants, there are many steps a plan sponsor can take to keep these potentially bothersome situations from becoming big headaches.

Since many fees are based on participant counts and many plan notices     (participant fee disclosures, summary annual reports, etc.) must be provided     to former employees with balances, eliminating those balances can save the     plan/plan sponsor money. By being proactive in this area, sponsors can keep     their plans lean and running at peak efficiency.

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