2-Loan Limit, Participant Pays Off 1 Loan, Obtains New Loan and Payoff Check Bounces

[Guest rocnrols2]

Plan X is a 401(k) plan allowing up to two loans to be outstanding at any time. P has two loans outstanding. P wants to pay off one of his loans and take a new loan. Following plan procedures, he requests a payoff amount and then sends a check to payoff the loan. P then requests a new loan. After the proceeds of the new loan are paid to him, P's check that paid off one of the previously outstanding loans bounced. Short of immediately taxing P on the new loan amount, are there any suggestions on how to correct this?

[Guest jhilliard]

We had a similar situation on a plan, the plan sponsor actually approached the participant with the option of issue a new check (should not bounce now that he received new loan) or deem it taxable immediately. The problem with deeming the loan is that a deemed loan is considered an outstanding loan. We were fortunate in that the participant issued new check that cleared.

Good luck

[FundeK]

Does anyone have any additional comments on this post?

[FundeK]

One more try....

I have a participant who had 2 loans outstanding. She sent in a payoff for loan #1, took another loan #3, and of course the check bounced. She can not submit another payoff. How do you handle these?

Is loan #3 considered to be deemed distribution at the time it was issued? I would assume the participant knew the check was going to bounce. Does that make loan#3 a sham loan?

[Harwood]

jhilliard has the best, pratical solution: get another check - one that clears - from the Participant.

[FundeK]

Can't, she won't provide one. That is the problem. She caused the operational failure, but won't resolve the problem. How do you force the participant to send a check? She doesn't care that the loan will be considered a deemed distribution.

[Belgarath]

So have it a deemed distribution, and leave it at that. I'd also, if I were the Plan Administrator, document the situation, and change my procedures so that in the future, a new loan check will not be issued until the payoff has cleared. Call me foolishly naive, but I find it unimaginable that the IRS would disqualify a plan if they picked this up on audit, and the documentation/procedures are in place so that this could not happen again.

[Earl]

Maybe loan #3 should be deemed also since it is not a permissable loan.

[FundeK]

Thanks for the replies. We have decided to deem the 3rd loan since it is the loan that sent the participant over the 2 loan limit. She has, of course, made payments on the third loan already! Should those be reclassified as deemed loan repayments, or would you apply them to loan # 1 that had to be put back into and active status because the check bounced?

One more question....If the plan allows, and the participant can provide supporting documentation, how would you feel about "reclassifing" as a hardship?

[Earl]

I would apply the payments to whatever loans were not defaulted when the payments were received. (not the 3rd one)

Reclassify.... When the money went out it wasn't a hardship distribution. I wouldn't mess with that.

[Guest halka]

How about pursuing collection of the bad check by getting judgment that results in garnishment of participants wages? Don't know that a judgment constitutes "loan repayment" but at least it gets things rolling -- and metes the appropriate punishment on the transgressor.

While a deemed distribution might be the quicker/simpler solution (I'd go for the third/new loan), it really achieves exactly what the participant wanted in the first place.

[Guest pjb]

Can the first loan be considered refinanced?