Our 401(k) plan allows participants to take loans from their accounts. We have a written policy that describes how the loans work and spells out the requirements that the plan and participants must follow. Among other details, the loan policy indicates that payments must be made via payroll deduction.
Since loan payments are withheld via payroll deduction, are they treated the same as deferrals? Also, do loans impact a participant's credit score?
Participant loans…for all the convenience they offer to participants, they are also the source of many questions just like these. Let’s start with the second one first since it has a shorter answer.
We used to see loan policies that suggested employers would assess the creditworthiness of a participant seeking a plan loan, which would presumably entail things like credit checks. In practice, however, we do not recall hearing of any employers that actually went through that process, and most of the loan policies we see now specifically indicate that there will be no such review. Some policies do include a provision that a participant will not be granted a loan if he or she already has a loan from the plan that is in default. Even if there is not that type of overt prohibition, the outstanding balance of a defaulted loan does count against the maximum amount a participant can take as a subsequent loan. Beyond that and the tax ramifications, there generally are not any additional punitive actions (such as a negative mark on a credit report) taken against the participant in the case of a loan default.
Now, back to your first question. You are correct that participant loan payments may appear similar to deferrals in that they are both withheld from payroll and remitted to the plan, but that is where the similarities end. There are several critical differences.
Fortunately, once you know them, both of these answers are relatively straight-forward to apply. Most payroll systems are setup to properly handle loan payments with regard to taxation and application of the limits as long as the key details are added at the time the loan is setup. Also, loan payments should not be included with deferrals or other contributions on the year-end census that you submit to your TPA. Of course, if you’re not sure how to proceed in a specific situation, give us a call. We are glad to work through it with you and point you in the right direction.
For more information on participant loans, including how to deal with those that have gone into default, please visit our Knowledge Center here, here, and here.
Want a printable version of this article? Click here.