New IRS Position On Plan Loan Interest Rate
401(k) and other qualified retirement plans frequently allow participants to borrow money from their accounts under the plan. The IRS recently pronounced the interest rate that it deems to be acceptable for plan loan purposes. The new IRS standard (and the consequence of not adhering to the IRS standard) is discussed below.
A plan may allow for plan loans, but only if the interest charged on the loan is "reasonable." In this connection, the applicable federal regulations hold that a rate will be "reasonable" if it is "commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances." For simplicity's sake, most employers do not actually take the trouble of ascertaining the interest that a bank would charge in regard to a loan made to a particular participant, based on the participant's unique creditworthiness. Rather, retirement plans almost uniformly charge a rate that is equal to, or a factor of, the current prime rate. The most common rates are prime, or prime plus 1%.
All was fine until the IRS released the transcripts of a recent phone forum concerning plan loans. The phone forum was conducted by the IRS's Employee Plans Examination Mandatory Review Manager. This division of the IRS is a quality control unit that makes sure that IRS retirement plan auditors apply IRS policies and practices in a uniform and consistent manner. The Manager pronounced that the plan loan interest rate deemed reasonable by the IRS is prime plus 2%. Specifically, he stated as follows: "Generally, the prime interest rate is a rate that banks only give to their very best customers and rare, very rare at that. For this reason, as a general rule, the Service generally considers prime plus 2% as a reasonable interest rate for participant loans, and I hope that helps you. …There could be, I guess, an argument that you could make or somehow that you could offer a rate that's less than prime plus two that would be reasonable, but you'd have to make that argument. Could this taxpayer, could this individual, this participant go out and get a loan for less than that in the open market? I guess that's a question you need to ask yourself and if the answer is no, then I think prime plus two is reasonable. If you can show documentation that the participant can go out and get a loan at a lower rate then that's what you'll need to be able to prove to the agent that's out there looking at this particular loan, so just something to kind of keep in mind. Like I said, it's nothing that's etched in stone, but it is a general guideline that we go by here at the Service."
A plan loan that does not carry a reasonable interest rate will constitute a prohibited transaction giving rise to excise penalty tax. Therefore, with the IRS now having voiced an opinion as to what constitutes an acceptable interest rate, it is our recommendation that plans which currently do not charge the IRS-sanctioned "prime plus 2%" plan loan interest rate (which is still a bargain) modify their loan policies to do so. It would not be appropriate to do so for current, outstanding loans, but the new rate can be applied to future loans. The change will require an amendment of the plan loan policy, and appropriate modifications to all plan loan documents.For further information or questions regarding this plan loan interest rate matter, please contact the Schwabe attorney with whom you work or Wally Miller at 541-686-3299 or email@example.com.