We recently handled an issue for a client that highlights the importance of overseeing plan service providers. You may ask why that is true, since service providers are in the business of helping administer retirement plans. A plan sponsor can just assume the plan is being administered correctly, right? The short answer is no -- even reputable companies make mistakes.
In this case, the issue related to the administration of participant loans. Many, if not most, 401(k) plans permit plan participants to take loans from their accounts. While plan loans are permitted by the Internal Revenue Code (the “Code”), there are a number of restrictions that apply. If the loan fails to comply with these restrictions, it can result in a “deemed” taxable distribution to the participant and potentially to a qualification error for the plan.
Generally, plan loans must be issued for a term that is 5 years or shorter. There is an exception, however, if the loan is “used to acquire a dwelling unit which will within a reasonable time be used as a principal residence of the participant.” Where the loan is used for that purpose, the term may be for a longer period set by the plan or the loan policy; often, the term can be as long as 30 years. But if a residential loan is made, what evidence or documentation should be obtained to establish that the loan is being used for that purpose, and, equally as important, who should obtain it? Is a representation by a participant sufficient?
In the case involving our client, the agreement with the plan service provider indicated that it would obtain documentation necessary to verify the purpose of the loan. Unfortunately, when the IRS questioned whether the loans were, in fact, proper residential loans, neither the plan sponsor nor the service provider had detailed records, such as a copy of the purchase agreement or other similar documents. (While there is no explicit requirement for such proof in the Code regulations or other IRS guidance, we are aware of several instances in which the IRS raised this issue, indicating that such documentation was necessary to demonstrate that the loan was proper.) It is not surprising that the plan sponsor lacked the records, since it thought it had delegated the job of obtaining proper documentation to the service provider. At the same time, the plan sponsor did not know that the service provider also lacked the information.
There are two morals to this story, one of which is obvious and the other of which is less so. The first is that plan sponsors should check their loan practices and procedures to make sure that appropriate evidence (beyond a participant representation) is being obtained in connection with residential loans. Plan sponsors may address loan procedures in one of two main ways. The plan sponsor may develop policies and procedures that it follows in-house in administering loans. Alternatively, the plan sponsor may rely upon a third party administrator to adopt and implement policies and procedures for administering loans. The second moral is that even if it is relying on the third party administrator, the plan sponsor should monitor the administrator periodically to ensure that the policies and procedures are actually being followed.