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Reasonable interest rate on plan loans

“What interest rate should a plan apply as part of its plan loan program?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Ohio is representative of a common inquiry related to 401(k) plan loans.

Highlights of Discussion

Loans to 401(k) plan participants are generally prohibited unless they

  • Are available to all plan participants and beneficiaries on a reasonably equivalent basis;
  • Are not made more readily available to highly compensated employees, officers or shareholders than they are to other employees;
  • Are made in accordance with specific provisions set forth in the plan;
  • Are adequately secured; and
  • Bear a reasonable rate of interest [see DOL Reg. § 2550.408b-1].

The Department of Labor (DOL) gives us a guideline for what is reasonable, but with room for interpretation. According to DOL Reg. § 2550.408b-1(e), a plan’s loan interest rate is reasonable if it is equal to commercial lending interest rates under similar circumstances (see also DOL Advisory Opinion 81-12A). In an example, the DOL explained, “The trustees, prior to making the loan, contacted two local banks to determine under what terms the banks would make a similar loan taking into account the plan participant’s creditworthiness and the collateral offered.”

The IRS has similar requirements in order for a plan loan to avoid excise tax under Internal Revenue Code Section (IRC §) 4795(c) and (d)(1) for prohibited transactions. In a September 12, 2011 IRS phone forum, IRS personnel stated informally: “… as a general rule the Service generally considers prime plus 2% as a reasonable interest rate for participant loans.”

The prime rate is an interest rate determined by individual banks, and is often based on a review of the Federal Reserve Boards’ H.15 Selected Interest Rates release of prime rates posted by the majority of the largest 25 banks in the U.S.  Prime is often used as a reference rate (also called the base rate) for many types of loans.[1] Conceivably, adding one or two percentage points to the prime rate makes the interest rate charged to a participant more consistent with general consumer rates, as individuals can rarely get a loan at the going prime rate.

In its Winter 2012 publication, “Retirement News for Employers,” the IRS suggests asking the following questions to determine if a loan interest rate meets the reasonable standard:

  • What current rates are local banks charging for similar loans (amount and duration) to individuals with similar creditworthiness and collateral?
  • Is the plan rate consistent with the local rates?

According to Internal Revenue Manuals, Part 4, Section 4.72.11.4.2.1.1, IRS examination steps related to verifying a reasonable rate of interest include

  • Determining whether the plan loans’ interest rates and other conditions are comparable to the terms of similar commercial loans in the relevant community; and
  • Checking the overall rate of return on plan assets when a large percent of the plan’s assets are invested in participant loans.

On the second point above, even if the interest rate on the loans is reasonable, the overall rate of return might be unreasonable. This could occur if it is determined that a plan’s substantial investment in participant loans is causing the overall rate of return to be materially less than what could have been earned in other investment options under the plan. The DOL has opined that a participant loan as an investment would not be prudent if it provided the plan with less return, relative to risk, than comparable investments available to the plan.

Conclusion

Determining reasonableness is a question of fact and circumstances, and there is no DOL or IRS “safe harbor” rate. Plan sponsors’ must 1) take into consideration relevant current market conditions, and 2) conduct periodic reviews of the interest rate to ensure it continues to reflect current market conditions. Anytime a participant loan is refinanced, the interest rate should be reviewed and updated, if needed. Above all, plan sponsors must be able to document the process they used to determine reasonable interest rates for participant loans in order justify their selection.

[1] https://www.federalreserve.gov/faqs/credit_12846.htm

 

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After-Tax Contribution Limits in 401(k) Plans

“What are the considerations for a 401(k) plan participant who wants to “max out” his/her after-tax contributions in the plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Ohio is representative of a common inquiry related to after-tax contributions in 401(k) plans.

Highlights of Discussion

  • There are several considerations for making after-tax contributions to a 401(k) plan, including whether the plan allows for after-tax contributions and, if so, what limits apply.
  • In order for a participant to make after-tax contributions to his or her 401(k) plan, the plan document must specifically allow for this type of contribution. For example, using our “Plan Snapshot” library of employer plan documents, RLC was able to confirm that the 401(k) plan in question does permit after-tax contributions.
  • Additional considerations when making after-tax contributions include any plan specified contribution limits; the actual contribution percentage (ACP) test; and the IRC Sec. 415 annual additions test.
  • Despite having a plan imposed contribution limit of 50 percent of annual compensation according to the plan document, the advisor determined his client could maximize his pre-tax contributions and still make a large after-tax contribution as well.
  • After-tax contributions are subject to the ACP test—a special 401(k) test that compares the rate of matching and after-tax contributions made by those in upper management (i.e., highly compensated employees) to the rate made by rank-and-file employees (i.e., nonhighly compensated employees) to ensure the contributions are considered nondiscriminatory. Even safe harbor 401(k) plans are required to apply the ACP test to the after-tax contributions if any are made. If the plan fails the ACP test, a typical corrective method is a refund of after-tax contributions to upper management employees.
  • In addition, each plan participant has an annual total plan contribution limit of 100 percent of compensation up to $54,000 for 2017 and $55,000 for 2018, plus an additional $6,000 for catch-up contributions, under IRC Sec. 415 (a.k.a., the annual additions limit). All contributions for a participant to a 401(k) (e.g., salary deferrals, profit sharing, matching, designated Roth and after-tax) are included in a participant’s annual additions. If a participant exceeds his annual additions limit, a typical corrective method is a refund of contributions.
  • In general, a 401(k) plan participant can convert his after-tax account balance to a Roth IRA while working as long as 1) the plan allows for in-service distributions; 2) the after-tax contributions and their earnings have been segregated from the other contribution types in a separate account; and 3) the participant follows the standard conversion rules (IRS Notices 87-13, 2008-30 and 2014-54).

Conclusion

Roughly one-third of 401(k) plans today offer participants the ability to make after-tax contributions.[1]  While this may be viewed as a benefit from many perspectives, there are several important considerations of which plan participants must be aware.

[1] Plan Sponsor Council of America, 59th Annual Survey; and Retirement Learning Center Plan Document Database, 2018

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“Off Again” Form 5500 Compliance Questions

“For the past couple of years, the IRS has added some extra compliance questions to the Form 5500 and related schedules—but told plan sponsors not to answer them. What is the current status of these questions?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from California is representative of a common inquiry related to Form 5500.

Highlights of Discussion

You are correct. For the 2015 and 2016 filings, the IRS added compliance questions to Forms 5500, 5500-SF, 5500-EZ and Schedules H, I and R. But, for each year, the IRS later instructed filers not to answer them. The IRS removed these additional questions from the 2017 version of Form 5500 and related schedules, which plan sponsors will file later in 2018 (see the 2017 Instructions to Form 5500).

“The IRS-only questions that filers were not required to complete on the 2016 Form 5500 have been removed from the [2017] Form 5500 and Schedules, including preparer information, Schedules H and I, lines 4o, and 6a through 6d, regarding distribution during working retirement and trust information, and Schedule R, Part VII, regarding the IRS Compliance questions.”

Be aware, however, that the DOL/IRS/PBGC are working on a long-term project that would improve and modernize Form 5500 in the areas of financial and other annual reporting requirements, and make the investment and other information more data mineable. We expect more updates to come in 2018.

Conclusion

The on again, off again additional IRS compliance questions on Forms 5500 are officially off the 2017 version of the forms that plan sponsors will file in 2018. There is more to come regarding a long-term project to overhaul the forms.

 

 

 

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Important Dates & Deadlines

March 15 –

  • Deadline for corrective distributions for failed ADP/ACP tests without the 10% excise tax for calendar-year plans without eligible automatic contribution arrangements (EACA). For non calendar year plans, the deadline is 2 ½ months following the end of the plan year.
  • Deadline for corporate tax return, requesting automatic extensions for corporate tax return, and deductible employer contributions to qualified plans (without extension)

 

April 2 –

  • Deadline to distribute first required minimum distribution (RMD) to participants and IRA (traditional, SEP and SIMPLE) holders who have reached their required start date
  • Deadline for filing Form 1099-R electronically with the IRS for each IRA holder, plan participant or beneficiary who received a distribution during 2017

 

April 17 –

  • Deadline for individual and/or partnership tax returns
  • Contribution deadline to traditional and Roth IRAs for 2017
  • Deadline for requesting automatic extensions for individual and/or partnership tax returns
  • Contribution deadline for unincorporated entities (without extension)
  • Deadline for corrective distributions of 402(g) excess deferrals from 2017 (calendar and non-calendar year plans)

 

May 15 –

  • Deadline for providing Q1 2018 participant benefit statements (including fee disclosure) to participants in participant-directed plans. For non-calendar-year plans, quarterly benefit statements are due no later than 45 days following the end of the quarter to which the statement relates.
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An Eye on DB Plans

As we approach the second quarter of 2018, we continue to see activity with defined benefit plans to reduce plan sponsor long-term liability (i.e., de-risking).  Many companies have implemented changes to how future benefits accrue, what forms of distributions are available (e.g., adding a lump sum) and what entity (e.g., an outside insurance company) is responsible for paying promised benefits. Three primary pressures contribute to these decisions: continued low interest rates, longer participant life expectancies and increased Pension Benefit Guaranty Corporation (PBGC) premiums. We can expect a continuation of plan de-risking in the future.  

 

Another trend we have seen recently is the large number of companies voluntarily contributing amounts above the required contribution to their defined benefit plans.  Many of these companies capitalized on the low interest rate environment and issued debt to pay down the funding shortfalls of the plan. History has shown that fully funding a company’s pension plan could be a precursor to a de-risking decision by the company.  These decisions could lead to opportunities for discussions with clients to help them understand what may be happening with their pension plans. If the company decides to offer a lump sum option, there may be money-in-motion opportunities. Likewise, if a company decides to transfer risk to an outside insurer it is an opportunity to educate clients and strengthen your relationship.

 

Pension De-Risking Activity 2018  
Graphic Packaging Lump-sum & transfer
L3 Technologies Plan Freeze eff. 1/1/2019
Alcoa Plan Freeze eff. 1/1/2021 & 3% contribution to DC plan for affected employees
Arconic Plan Freeze eff. 4/1/2018
DuPont Plan Freeze eff. 11/30/2018

 

 

Excess Pension Contributions 2018
FedEx $1.5 billion
Exelon $652mm
3M $500mm
Alcoa $300mm
Mondelez $289mm
United Technologies $100mm
Lockheed Martin $5 billion
AbbVie $750mm
Huntington Ingalls $508mm
Motorola $500mm
DTE Energy $200mm
Consolidated Edison $473mm
Graphic Packaging $75mm

Sources:  SEC Forms 8-K and 10-K filings

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The Bipartisan Budget Act’s Impact on Hardship Distributions

The rules applicable to hardship distributions from qualified plans have been relaxed as a result of the Bipartisan Budget Act, which was passed February 9, 2018.  Effective for plan years beginning January 1, 2018, hardship distributions are modified in the following ways.

 

  • Participants no longer have to exhaust plan loans prior to receiving a hardship distribution.
  • Participants are now able to include qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs) (as well as earnings attributable) when determining the amounts available for hardship distribution.
  • The bill directs the IRS to modify the regulations governing hardship distributions to eliminate the requirement to suspend employee deferrals for six months following a hardship distribution.
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Recharacterization Of Roth Conversions – Going, Going, Gone

Since their inception in 1998, taxpayers have had the ability to accumulate tax-free wealth for retirement in Roth IRAs.   Eligible individuals can fund Roth IRAs through annual, after-tax contributions or taxable conversions from qualified retirement plans and traditional IRAs.  What’s more, Roth IRA owners could undo or “recharacterize” their contributions and conversions for any reason within a set timeframe and not suffer any tax consequences.  The deadline for completing a recharacterization is the individual’s tax filing due date, plus extensions. Individuals who file their return by the deadline have an automatic six month extension (October 15 of the year following the tax year).

While tax payers are still able to recharacterize contributions, time is running out for them to recharacterize conversions.  When the Tax Cuts and Jobs Act was enacted it included a provision that eliminates recharacterizations of converted amounts effective for 2018 and later years.  The IRS has clarified that individuals can still recharacterize amounts converted in 2017 as long as they do so by October 15, 2018. Amounts converted after December 31, 2017, can no longer be recharacterized.

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Plan Compensation and Imputed Income

“What is imputed income and how does it affect a 401(k) plan, if at all?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Virginia is representative of a common inquiry related to compensation.

Highlights of Discussion

Imputed income relates to group term life insurance (GTLI). Offering GTLI may affect the administration of an employer’s qualified retirement plan, depending on the definition of compensation selected for plan purposes.

The first $50,000 of employer-provided GTLI is excludable from an employee’s taxable income pursuant to Internal Revenue Code Section (IRC) §79. Once the amount of coverage exceeds $50,000, the imputed cost of coverage, based on the IRS Premium Table, is subject to income, Social Security and Medicare taxes (see IRS Publication 15-B). The imputed income is considered a taxable fringe benefit to the employee.

An employer must report the amount as wages in boxes 1, 3, and 5 of an employee’s Form W-2, and also show it in box 12 with code “C.” At an employer’s discretion, it may withhold federal income tax on the amount.

As taxable income, the amount may be included in the definition of compensation that is specified in the governing documents of an employer’s retirement plan. For example, with respect to the safe harbor definitions of compensation that plans may use, treatment of imputed income is as follows.

Compensation Type Form W-2 3401(a) 415 Safe Harbor
Taxable premiums for GTLI Included Excluded Included

 

Conclusion

Imputed income from GTLI coverage may be includible compensation for retirement plan administrative purposes. Employers and plan administrators must always refer to the specific definition of compensation elected in the plan document to know when to include or exclude imputed income.

 

 

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