(b)lines Ask the Experts – Payroll Versus ACH Deductions for Loan Repayments

David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer: 

Not particularly. As we cited in our Ask the Experts Q&A on reining in loan use, both methods are far more preferable to the use of traditional coupon repayments in reducing the number of loan defaults that can plague some retirement plans.

However, some plan sponsors may have a clear preference due to the following factors:

1)      ACH loans do NOT involve any interface with the payroll system at the plan sponsor, while payroll deduction obviously does—thus, payroll deduction typically means more work for the plan sponsor. At smaller nonprofits that utilize outside payroll providers, this may not be an issue, but for those who do not outsoruce payroll, the interface with the recordkeeper can range from a small amount of additional effort to a true administrative burden, dependent of the technology and the complexity of the payroll system(s).

2)      Leaves of absence are easier to handle with ACH—if an employee goes on an unpaid nonmilitary leave of absence, with ACH there are no issues since the deductions are made from the employee’s checking account. However, with payroll deduction, an alternate means of repayment must be created, since there are no paychecks from which a loan can be deducted during a leave. For this reason, certain types of organizations who have large numbers of employees who take leave, such as health care and colleges/universities, are less likely to use payroll deduction in the Experts’ experience.

3)      Payroll deduction loans have the potential to be more problematic upon employment termination—obviously, when an employee terminates employment, he/she is no longer being paid. If payroll deduction is the ONLY option at a recordkeeper for loan repayment (and this is the case with some recordkeeping platforms, particularly at smaller providers), then the employee will be responsible to pay the entire outstanding loan balance at termination of employment or be taxed on that balance, which is obviously an undesirable event. However some recordkeepers, if the plan permits, will permit the loan repayments to be converted to ACH or coupon after employment termination, which then allows the former employee to continue to repay the loan as intended. However, for plans with ACH repayments, employment termination is a non-issue, assuming that the plan permits the loan repayments to continue following employment termination.

Also, keep in mind that if a participant has ever defaulted on a prior loan from the plan and had a deemed distribution as a result, the Internal Revenue Service (IRS) regulations provide that for any further loan, repayment has to be repaid by payroll withholding or the loan has to be adequately secured in addition to the participant’s accrued benefit under the plan. (This is under Treas. Reg. section 1.72(p)-1, Q&A-19(b)(2).). A loan being secured by additional collateral held outside of the plan is a rare event in the Experts’ experience. Thus, payroll deduction is generally the only repayment option following a loan default, if the plan even permits re-borrowing after a default.

Of course you need to check with your recordkeeper to confirm which loan repayment options are permitted, as well as review the applicable provisions of your plan document (and loan policy, if applicable) before contemplating any changes to repayment procedures. Also, with respect to any repayment option, any fees charged should be reviewed for reasonableness as well.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.