Like many businesses, yours may allow retirement plan participants
to take out loans from their accounts. Such loans are governed by many IRS and
Department of Labor (DOL) rules and regulations. So if your company offers plan
loans, your plan document must comply with current laws — including setting a
“reasonable” interest rate.
Agency perspectives
Neither the IRS nor DOL provides a set percentage for plan
sponsors to use. Yet both require the rate to be “reasonable.” The IRS asks if
the interest rate is similar to local interest rates and to what local banks
charge individuals for similar loans with similar credit and collateral.
Meanwhile, DOL regulations say that an interest rate is reasonable if it’s
equal to commercial lending interest rates under similar circumstances.
The DOL provides several examples of how to determine the
interest rate. For example, suppose the plan loan interest rate is set at 8%,
but local banks offer between 10% and 12% for similar circumstances. In this
example, the loan will fail to meet the reasonable standard.
Keep in mind that the plan participant pays the interest to his
or her own retirement plan account. That’s one reason why charging an interest
rate that’s lower
than what local banks are charging isn’t considered reasonable. The purpose of
charging interest on retirement plan loans is to help prevent long-term harm to
the participant’s retirement nest egg.
Ill consequences
If your plan fails to assess a reasonable interest rate,
participant loans may result in a prohibited transaction. What does this mean?
Prohibited transactions are certain transactions between a retirement plan and
a disqualified person. Disqualified persons taking part in a prohibited transaction
must pay a tax.
A prohibited transaction includes the lending of money or other
extension of credit between a plan and a disqualified person. However, the laws
specifically exempt plan loans from the prohibited transaction list as long as
they comply with applicable rules. If your interest rate isn’t reasonable, the
plan loan may lose its exempt status and become subject to the prohibited
transaction tax.
Ongoing task
Ensuring you’re offering a reasonable plan loan interest rate is
an ongoing task. Review your plan document and loan policy statement to
determine whether the plan sets an interest rate. You may need to update the
document to comply with the more recent regulations and interest rates. We can
help you with this review, as well as in calculating a reasonable rate.
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