Employers and plan administrators will be better able to administer plan loans and meet the prohibited transaction exemption, since the IRS has given them a clearer picture of what constitutes a “reasonable rate of interest.” The IRS has provided this assistance in guidance it published in the Winter 2012 edition of its “Retirement News for Employers.”
The guidance came roughly five months after an IRS phone forum on plan loans, during which two IRS employees off-handedly stated that the service generally considers “prime plus 2 percent” to be a reasonable rate of interest. At the time, many plan loan programs used an interest rate of less than prime plus 2 percent, so the remark led many plan administrators to question whether they should adjust their rates.
While the remarks during that September phone forum were unofficial, this latest guidance from the IRS comes with the full weight of the service’s authority. However, while the IRS did not address which specific interest rate(s) it considers ideal, it did provide methods on the best way to calculate a reasonable interest rate for a plan, as well as three examples illustrating them.
In its newest guidance, the IRS quoted the Department of Labor (DOL) Reg. §2550.408b-1(e):
A loan will be considered to bear a reasonable rate of interest if such loan provides the plan with a return commensurate with the interest rates charged by persons in the business of
lending money for loans which would be made under similar circumstances.
To determine if a participant loan interest rate is reasonable, the IRS instructed, plan administrators should ask two questions:
- What current rates are local banks charging for similar loans (amount and duration) to individuals with similar creditworthiness and collateral?
- Is the plan rate consistent with the local rates?
Another resource to consider in determining a reasonable rate of interest for a plan is the daily summary of prime rates, to which the IRS said it regularly refers. Determining a reasonable rate of interest is imperative for plan loans — they must do so in order to meet the prohibited transaction exemption under Code Section 4975.