Troutman Sanders LLP: Interest Rate for 401(k) Plan Participant Loans May Need to Be Prime Plus 2%

By Jonathan A. Kenter, Evelyn Small Traub, Jeffery R. Banish, Lynda M. Crouse, Tina A. DeNapoli, Jeanne E. Floyd, Stephen G. Gorell, Kristina Rae Jones, Edith "Edie" Margaret Lindsay, Roger S. Reigner Jr., Mamta K. Shah and Wallace "Wally" M. Starke

During a recent phone forum, an IRS agent stated that the agency views an interest rate equal to prime plus 2 percent as a "reasonable" interest rate - effectively establishing a safe harbor rate. This advisory reviews this guidance and what action plan administrators may want to consider.

Generally, absent an exemption, a loan between a plan and a 401(k) plan participant is a prohibited transaction under ERISA. Among the requirements to escape prohibited transaction status, a participant loan must:

  • Be made available to all participants and beneficiaries on a reasonably equivalent basis;
  • Not be made available to highly compensated employees in an amount greater than the amount available to other employees;
  • Be made in accordance with specific provisions set forth in the plan;
  • Be adequately secured; and
  • Bear a reasonable rate of interest.

Under applicable Department of Labor Regulations, to be reasonable, an interest rate must be consistent with interest rates charged by commercial lenders for a loan made under similar circumstances. The regulations do not provide a safe harbor rate. 

Just as important as what the IRS agent said about a "reasonable" interest rate is what the agent did not say: Whether an interest rate of less than prime plus 2 percent would be considered presumptively reasonable.  Presumably, the answer would depend on the credit worthiness of each borrowing participant.  On that theory, there are undoubtedly participants whose credit worthiness is such that a bank would not issue them a loan at even prime plus 2 percent. 

Nevertheless, although the comments of an IRS agent during an IRS-sponsored phone forum are admittedly not official guidance, to minimize their fiduciary liability, plan administrators issuing participant loans at interest rates of less than prime plus 2 percent may wish to rethink issuing loans at this rate and replacing it with prime plus 2. 

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) that may be addressed herein.

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