Voluntary Correction Program – How to Correct 401(k) Plan Loan “Failures”

So you realized an error was made in the administration of your 401(k) plan’s loans, now what? The IRS will forgive errors involving 401(k) plan loans only when you use the Voluntary Correction Program (“VCP”). Correcting your plan mistakes through the VCP preserves the plan’s tax-favored status. One of the areas with the most frequent occurrence of errors is plan loans. There are three primary “failures” involving plan loans that require an IRS remedy: (1) loan defaults, (2) loans exceeding prescribed maximum dollar limits, and (3) loan terms that exceed repayment limits.

  1. Loan Defaults

When a participant defaults on a plan loan, there are two potential outcomes. The first possible outcome (and least desirable for the participant) is that the loan is treated as a “deemed distribution.” The plan must report the amount using the IRS Form 1099-R. In addition to the participant being taxed on the amount of the deemed distribution, there is a 10% penalty that is assessed, if the participant is younger than 59½.

The preferable scenario is that either the participant makes a lump sum repayment of the owed interest and principal, or the plan reamortizes the loan within prescribed term limits. In either case, the plan will need to use the VCP process to notify the IRS.

  1. Loans Exceeding Prescribed Maximum Dollar Limits

When a participant exceeds plan loan limits, the IRS permits correction, if there’s a payment to the plan based on the excess amount. Loan repayments made prior to the correction can be applied one of three ways:

  1. To interest on the excess so the participant repays only the excess loan amount,
  2. Only to the amount of the loan, not exceeding the dollar limit so that the participant repays the excess loan amount (plus interest), or
  3. Pro rata against the loan excess and the maximum loan amount, so that the corrective repayment equals the outstanding balance remaining on the original loan excess on the date that corrective repayment is made.

Avoiding the excess loan amount “failure” requires careful monitoring of loan activity, especially when participants take multiple loans. Plan participants can take a plan loan for the lesser of $50,000 or 50% of the participant’s nonforfeitable account balance.

However, when multiple loans are involved, the IRS reduces the $50,000 by the difference between the highest outstanding balance of all of the participant’s loans during the 12-month period ending on the day before the new loan, and the outstanding balance of the participant’s loans from the plan on the date of the new loan.

Let’s look at an illustration furnished by the IRS: Joan has a vested account balance of $100,000 and took a plan loan of $40,000 on January 1, 2016, to be paid in 20 quarterly installments of $2,491. On January 1, 2017, when the outstanding balance is $33,322, Joan wants to take another plan loan. The difference between the highest outstanding loan balance for the preceding year ($40,000) and the outstanding balance on the day of the loan ($33,322) is $6,678. Because the new loan plus the outstanding loan cannot be more than $43,322 ($50,000 – $6,678), the maximum amount that the new loan can be is $10,000 ($43,322 – $33,322).

  1. Loan Terms That Exceed Repayment Limits

The third common failure category is loans that fail to satisfy payment schedule requirements. Participants must pay off loans within five years, and make payments no less frequently than quarterly. The consequence for violating these limits is severe. The IRS treats the entire loan amount as a deemed distribution, including accrued interest.

The good news is that, if you use the VCP program, the participant might escape the penalty, if the error is recognized within five years after the loan’s issuance. However, the IRS “reserves the right to limit the use of the correction methods to situations that it considers appropriate, for example, where the loan failure is caused by employer action.”

Making the Correction

No matter which type of plan loan failure, you’ll need to file the VCP’s Form 8950 (“Application for Voluntary Correction Program (‘VCP’)”) and Form 8951 (“User Fee for Application for Voluntary Correction Program (‘VCP’)”) to make a correction. There’s a user fee that is paid along with the submission that generally is determined based on the number of plan participants. Of course, it’s better not to have the problem in the first place. Review your plan document’s loan language and transactions with your employee benefits advisor. Better safe than sorry.

© 2017

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