Most plan administrators and plan sponsors find participant loans to be a significant administrative challenge. To reduce the administrative burden and to make the loan program more cost effective, many 401(k) plans include provisions: (1) requiring payroll deduction to repay the loans, and (2) limiting the loans to active employees.

Must a plan make loans available to all participants?

No. However, the plan must satisfy the reasonably equivalent basis condition of the prohibited transaction requirements. To satisfy the “reasonably equivalent basis” condition, a plan must make loans to participants and beneficiaries available without regard to an individual’s race, color, religion, age, sex or national origin. The plan may take into consideration factors which a commercial institution in the business of making similar loans would consider, such as the applicant’s creditworthiness. In addition, the plan may consider financial need in determining loan availability.  

Under certain circumstances, uniformly applied loan requirements still might violate the requirement to make participant loans available on a reasonably equivalent basis, if the operation of the requirements results in a large percentage of plan participants not receiving loans. Of course a plan cannot make participant loans available to Highly Compensated Employees (HCEs) in a greater amount than to Non Highly Compensated Employees (NHCEs).

May a plan exclude former-employee participants from the plan’s participant loan program?

No. Under the “reasonably equivalent basis” rule, an employer may not design a loan program to exclude from eligibility all former-employee participants.  However, an employer may limit participant loans to former-employee participants who are parties in interest. Similar rules apply to beneficiaries of deceased employees and to alternate payees.