Death and Outstanding Loans

[Felicia]

I'm trying to determine how practioners handle situations where a participant takes out a loan and then dies before it is repaid.

Does your loan policy state that the loan will automatically go into default?

[R. Butler]

In our loan documents, death does trigger a default.

How can death not trigger a default?

[Appleby]

Death does not necessarily trigger default. If the participant has an outstanding loan balance (secured by his/her account) at the time of death, the loan is offset against the participant’s account balance…not sure what happens if the loan is not secure by the account balance

[R. Butler]

I'm probably missing something, but doesn't the default trigger the offset. I realize that the offset and the default may not occur at the same time, but why would there be an offset if there is no default?

[mbozek]

Why is death a different distribution event for a loan than termination of employment?

[R. Butler]

Death triggers the offset. Default does not trigger offset.

I disagree. The default is the reason for the offset. The offset can't occur until a distributable event, i.e. death, but if we say there is no default than there is no reason to offset.

[ljr]

We believe the estate of the deceased participant can repay the loan to avoid the offset and resulting Form 1099-R in the decedent's name.

Our situation was a non-spouse beneficiary of a wealthy participant who died with a loan balance due of over $40,000.

The family's attorney is considering whether or not the estate should repay the loan.

Any thoughts out there?

[Kirk Maldonado]

ljr:

Whether the estate can repay the loan depends on the terms of the loan. The estate has no independent right to be able to repay the loan if the loan documents would preclude it.

[mbozek]

Could some one explain the financial advantage of repaying the loan with after tax dollars? If the taxpayer was in the 32% tax bracket there would be a tax of $12,800 due on the phantom income. That is $27,200 less the $40,000 in cash needed to repay the loan, assuming that an estate can repay the loan (which I dont believe is possible under the terms of the note). The 27,200 saved by paying the tax on the phantom income can be invested in capital assets which will generate capital gain at a rate of no more than 20%. Both the $40,000 invested in the plan and earnings will be subject to income tax at a higher marginal rate.

[jane123]

This seems to suggest that death triggers an offset

QUOTE (yvonne001 @ Feb 21 2003, 06:33 PM)

The ERISA Outline book 2002 edition says "If a participant has an outstanding loan at the time of death, the participant's death will usually result in an offset of the unpaid balance against the accrued benefit. The participant (or the participant's estate), not the beneficiary, will be liable for any taxes resulting from that offset, because the beneficiary is not a party to the loan agreement. The tax liability might be reported on the participant's final income tax return or on the estate's income tax return..... The plan's loan policy might allow the beneficiary to assume the loan obligation and make repayment. A surviving spouse might do this, for example, in order to repay the loan and increase the amount available for rollover by the surviving spouse."

Quoted from this thread <a href='http://www.benefitslink.com/boards/index.php?act=ST&f=17&t=18623&hl=loan,and,death,and,deemed'>http://www.benefitslink.com/boards/index.p...eath,and,deemed</a>

Any comments- I have a similar issue- except that the loan is in default

[mbozek]

I dont know where the ERISA outline book gets the authority for such a statement. If death is a default event then the amount of the loan balance will be considered a distribution to the beneficary as sucessor in interest to the participant. Reg. 1.72(p)-1 Q 4. Since distributions from a qualfied plan are income in respect of decedent under IRC 691 the beneficary will be taxed on the amount of the distribution. The participant's tax final return includes those items of income paid up to the date of death. Amounts paid to the participant after death are taxed to the estate. If the participant's account balance includes the loan then the loan is an asset of the account and the beneficiary becomes the owner upon the death of the owner. I would be interested in how TPAs report such distributions.

[Appleby]

My initial reaction was similar to yours mbozek …but I did some digging and it appears that the ERISA Outline is right…this seems to be one of the exceptions to the rules you state above … Treas Reg § 1.401(a)-20 , Q & A 24(d)

[mbozek]

A: Interesting cite but I am not sure it answers the question of who is taxed on the outstanding loan balance since death benefits are taxed as IRD under IRC 691. Q-24(d) merely recites that the accrued benefit due the spouse under a plan is reduced by the amount of the outstanding loan.