Is Prime + 1% a Reasonable Interest Rate for Qualified Plan Loans?

September 26, 2011

Authored by: benefitsbclp

In a phone forum held on September 12, 2011, Internal Revenue Service (“IRS”) officials were reported by BNA Pension and Benefits Daily in a September 13, 2011 article by Florence Olsen as indicating that the Prime rate + 1% may not be a reasonable interest rate under the Internal Revenue Code prohibited transaction rules which apply to loans from qualified plans. For corrections and audit purposes, the IRS may be looking to the Prime rate + 2%. In recent years, plan administrators typically set the interest rate for plan loans as the Prime rate + 1% in effect on the first of the month during which the loan is originated (or a similar set date). If a participant can not secure a loan in the open market with an interest rate of Prime + 1%, the IRS official indicated that the Prime rate + 2% may be a more appropriate measurement of a reasonable interest rate.

A qualified plan loan is distinctly different than a loan obtained on the open market. Repayments are generally secured through payroll withholding and transmitted by the employer directly to the plan. In addition, the collateral for the loan is secure since it’s the participant’s own account balance in the plan. Therefore, the source of loan repayment and the collateral are likely to be more secure in the context of a qualified plan loan than a loan obtained in the open market. Arguably, these factors weigh in favor of a lower rate being reasonable in the context of a qualified plan loan than a rate which would apply to a loan obtained in the open market.

In order to dot the fiduciary I’s and cross the fiduciary T’s, plan administrators should periodically review the interest rate used for qualified plan loan purposes and document the reasons for establishing the rate at the level determined to be reasonable. These remarks by IRS officials may persuade some plan administrators to raise the plan loan interest rate to Prime + 2%.