Defaulted loans

[FAPInJax]

How are administrators handling loans that are defaulted???

For example, consider the following:

A plan does not provide for post-tax contributions. HOWEVER, a participant who has taken a loan, defaults on the loan but then decides to repay (for some unknown reason).

I believe this repayment is post-tax money which creates a basis in the plan.

First, is the repayment prohibited because the plan does not permit post-tax contributions???

Second, IF the repayment is NOT prohibited, then it creates a basis - correct??? When is the basis recoverable???

Another question regarding basis.

A plan permits post-tax contributions. The participant does a MAHVELOUS job of investing (in Enron or something) and their contribution of $1,000 is now worth $100. The participant elects to take a distribution of the post-tax money which comes out tax free because his basis of $1,000 covers the distribution. What happens to the remaining $900???? Is it ever recoverable????

Many thanks in advance to any and all respondees!!!!

[Tom Poje]

see 1.72(p)-1 Q-12

A deemed distribution is not an actual distribution.....

thus, it is a distribution for tax purposes, but the obligation to repay the loan still exists, so it does not matter whether the plan allows for post-tax contributions.

In fact, technically you need to continue to accrue interest on the loan. If the participant wants a new loan, the defaulted amount plus interest counts against the maximum he can borrow - it is still an outstanding loan.

Thus, when he repays the loan it will be for an amount = deemed distribution plus interest. his basis will be only for the deemed distribution amount, not the total paid back on the loan.

[FAPInJax]

Thanks for the input. All the information you provided was excellent.

HOWEVER, when is the basis recoverable? Imagine a participant who repays the deemed distribution plus interest of exactly $1,000. Generally, a subsequent distribution from the plan of post-tax money would generate tax free return of some portion of the $1,000. The plan does not have any post-tax money. Assuming the participant asks for a distribution of 25% of their balance (100% vested). Do they get to take the $1,000 tax free first OR must they prorate against the entire balance???

Same question for the second one. What happens to the remaining basis in the post-tax source?? Here the participant has a basis bigger than the source balance. Distributing all of the source balance only recovers a portion of the basis (equal to the source balance). When is the remaining basis recovered????

[jaemmons]

Frank,

Is this a defaulted loan (one which is deemed uncollectible) or a deemed distribution for failure to repay? If it is a defaulted loan, then the participant cannot repay the loan since it has been determined to be uncollectible. In this case, the account balance is offset by the outstanding loan balance.

If however, it is a deemed distribution, since the plan does not allow for after-tax contributions, the participant cannot repay the loan. Normally, plans which do not permit after-tax monies to be contributed but offer loans, establish in administrative procedures that the loan is deemed and offset with the secured account balance simultaneously. This helps the administrator, since they don't need to track outstanding loans for distribution purposes that have been deemed in a prior plan year.

Bottom line is that I don't feel that they can repay the loan.

[JohnCheek]

In the past, the DOL made it clear that deemed distribution loans do still exist, and continue to be an obligation of the borrower.

Even after a loan is deemed distributed, a participant should repay the loan if possible-- that allows for more money in his retirement account to grow tax-deferred, which was the whole point of having a retirement plan.

Repayment should not be considered an after-tax contribution, so whether a plan allows after tax contributions should not be relevant. Clearly, it can not "prohibit" repayment of the loan.

When repayment is made on a loan that was deemed distributed, that gives the participant basis in his retirement account, and that basis would be recovered based on the regular annuity rules, ie. ratably over his lifetime distributions.