This participant is no longer employed but has an outstanding loan on her 401k account. Her outstanding loan balance is roughly $12,000 but the market value of the account (excluding the loan of course) is roughly $3,000. The plan processes quarterly deminimis distributions. She is able to continue to make loan payments after leaving the employer.

Based upon this scenario, does the $3,000 balance allow the plan to cash her out and default the loan, or does the outstanding loan balance prevent the deminimis distribution?

I'm not aware of any official guidance, but here's my thoughts . . .

If the loan has not been deemed distributed, then her account balance currently is $15,000 (& she will receive a 1099-R for $15,000). Involuntary distribution provisions do not apply. Consent required.

If/when she ceases making loan repayments and the loan is deemed distributed (i.e., usually at the end of the quarter following the quarter when the first payment is missed)--& therefore when a 1099-R obligation arises--then I would say that the accrued benefit no longer includes the loan repayment obligation. At that point, if the accrued benefit is less than $5,000, involuntary distribution would be permissible (keeping in mind the IRA mandatory rollover issues and appropriate plan provisions).

Afterthought: Although I know that a deemed distirbution is not an actual distribution, the regs state that a "deemed distribution . . . is not a distribution of the accrued benefit." (Treas. Reg. Section 1.72(p), Q&A-13(a)(2).) It therefore would seem that my discussion (above) about an involuntary distribution following a deemed distribution is wrong--i.e., even deeming a loan will not reduce the accrued benefit by the amount of the deemed distribution in order to permit an involuntary distribution. Anyone with other thoughts, opinions?

Sieve,

I gathered from the OP that the participant is terminated and eligible for a distribution. That would make a loan default an offset instead of being deemed. I agree there can not be a cashout if she continues to make the payments.