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CCH® PENSION AND BENEFITS — 9/9/08

IRS provides guidance on finding, correcting and preventing 401(k) loan errors

In the latest issue of Retirement News for Employers, the IRS has provided guidance on the corrective steps which can be taken when mistakes are made in a 401(k) loan repayment which could result in the entire loan amount being considered a taxable distribution to the participant.

In an example provided by the IRS, a plan’s terms regarding 401(k) loans complied with Code Sec. 72(p)(2) requirements: they included the appropriate dollar limit on loans, called for level amortization over a period not to exceed five years (for loans not used to purchase a principal residence), and for repayments to be made at least quarterly. The plan did not, however, provide a “cure period” for missed loan payments.

In the example, it took nearly six months for the plan administrator to realize that, due to an inadvertent failure to forward loan information to the payroll department, loan repayments by payroll withholding were not being made for a participant who had received a plan loan. This would cause the entire outstanding loan balance, plus accumulated interest, to be treated as a deemed distribution.

Finding and correcting the error

In order to discover such errors earlier, the IRS recommends that, monthly, the plan reconcile the aggregate payroll deposits (employees’ elective contributions and loan repayments) to the plan, with the payroll amounts that should have been deposited to the plan. In order to correct the mistake, the IRS recommends that the employer request relief under the Voluntary Correction Program (VCP). The VCP permits the plan to correct certain participant loan failures and obtain relief from the IRS (see Revenue Procedure 2008-50, CCH Pension Plan Guide ¶17,299S-66). Relief requires correction of the error.

When the error is discovered, the plan administrator, in the example above, could correct the error in one of three ways:

(1) Require the participant to make a lump-sum payment of all missed installment payments, adjusted for interest, and continue to make the remaining installment payments from that point forward;

(2) Reamortize the outstanding balance of the loan, resulting in increased installment payments for the remainder of the loan period; or

(3) Require the participant to make a partial lump-sum payment for less than the sum of all missed installment payments, then reamortize the remaining balance of the loan, resulting in remaining installment payments which are higher than in option 1 above but lower than in option 2 above.

Avoiding future errors

In order to prevent such errors from occurring in the future, the IRS recommends:

(1) The plan institute procedures that would include evidence of receipt of the loan information by the payroll department before a check is issued for the loan.

(2) The plan include a cure period which would give the plan administrator time to take corrective action without negative consequences. For example, a plan could provide that a loan does not become a deemed distribution until the end of the calendar quarter following the quarter in which the payment was missed.

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