Deemed or Defaulted

[Guest walpadopolis]

What exactly is the defining difference between a "deemed" and "defaulted" loan?

[R. Butler]

I assume you mean the difference between a loan default and a deemed distribution.

A loan default is triggered by the provisions of the loan document. Generally loan defaults occur to due termination of employment or failure to repay. However, review the doucment; the document should list events that trigger a default.

If at the time of default, the participant has money available for withdrawal, the available balance is generally used to offset the loan. If there isn't a distributable event, the loan cannot be offset and instead will be treated as a deemed dsitribution. The amount of the deemed distribution is taxable to the participant at the time of default, however, the loan continues to be an outstanding loan and continues to accrue interest.

In short the default is triggering event that leads to a deemed distribution.

[Guest bmurphy]

I understand the taxability of the deemed distribution. What happens to the interest that continues to accrue on the loan. Does that come into play when there is a distributable event & the loan is offset? Also does the interest accrue based on the rate stated in the promissary note? If the person terms but doesn't take their money out (balance over 5k so can't force pay) it sound like we'd need to carry the loan (plus accrued) until such time as they elect a distribution. Is this correct? Any guidance is appreciated.

[lkpittman]

If you've got a terminated ee who has elected to keep his or her account in the plan, you still have a "distributable event" and can "distribute" the loan amount by issuance of a 1099-R (that reflects and actual distribution, rather than a deemed distribution).

[R. Butler]

I essentially agree with lkpittman, probably can offset the loan. Check the loan provisions and make sure that termination triggers repayment. I've seen documents that actually allow terminated employees to continue to repay (or at least are silent on the issue). In such cases termination of employment doesn't automatically mean defaulted loan.

Just to answer your questions on deemed distributions. Interest does continue to accrue at the stated rate. It is "phantom" interest and will not be taxed again at loan offset.