The Reasoning of Interest Rates
Make Sure Your Plan Loan Interest Rate is Reasonable
Plan loans are governed by many IRS and DOL rules and regulations. If you choose to offer plan loans to your participants, your plan document must comply with the current laws, including the interest rate charged on these loans. Some plan documents stipulate an interest rate, while others do not.
What is a Reasonable Interest Rate
What is a reasonable interest rate? Unfortunately, the regulators do not publish a schedule of reasonable interest rates. Instead, the regulators provide guidance in assessing reasonableness. Neither the IRS nor DOL provides a set percentage for plan sponsors to use; however, both require the rate to be reasonable. The IRS asks if the interest rate is similar to local interest rates, and what local banks charge individuals for similar loans with similar credit and collateral. DOL regulations provide 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 loans under similar circumstances. In this case, the loan will fail to meet the reasonable standard.
The Consequences of Unreasonable Rates
If the plan fails to assess a reasonable interest rate, participant loans may result in a prohibited transaction. 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.
The various scenarios that can possibly give rise to a prohibited transaction are numerous. 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. If your interest rate is not reasonable, the plan loan may lose its exempt status and become subject to the prohibited transaction tax.
Time for Review
Review your plan document and loan policy statement carefully to determine if the plan sets an interest rate. Consider updating the document to comply with current regulations and interest rates if you haven’t done so recently.
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