Accepting loan payoff for a loan that should have been offset.

[FundeK]

Can anyone comment on the following scenario?

Participant terminated employment 12/03 with an outstanding loan. For some reason, the loan was never offset. Can the plan now accept a total repayment of this loan?

I understand the loan was in default when one payment was missed, and that the loan should have been offset following a "reasonable period of time" as stated in the loan policy. But, this was not done.

Since a loan offset is an eligible rollover distribution, why couldn't you accept total repayment and keep the funds in a pre-tax status? Any cites would be greatly appreciated.

Thanks

[E as in ERISA]

How clear is plan regarding timing of offset? Failure to follow plan terms re offset may be an operational violation.

However, failure to try and collect loans can be a fiduciary violation and make loans prohibited transactions. See preamble to 200 proposed regulations: "The Department of Labor (DOL) has advised the IRS that, with respect to plans covered by Title I of the Employee Retirement Income Security Act of 1974 (88 Stat. 829) (ERISA), the administration of a participant loan program involves the management of plan assets. Therefore, fiduciary conduct undertaken in the administration of such a loan program must conform to the rules that govern transactions involving plan assets. In particular, a loan program must be administered in a prudent manner, solely in the interest of the participants and beneficiaries, and for the exclusive purpose of providing benefits to participants and beneficiaries. See, generally, ERISA sections 403, 404, and 406. In the view of DOL, it is questionable whether a participant loan program of a plan covered by Title I of ERISA that does not provide for timely repayment of loans (through payroll withholding or otherwise), regular and effective collection efforts following a default, and adequate security for the plan in the event of default would be in compliance with the rules applicable under Title I of ERISA to transactions involving plan assets. In the view of DOL, it is also questionable whether such a program would qualify for the relief provided under section 408(b)(1) of ERISA. See Preamble to 29 CFR 2550.408b-1, (54 FR 30520, 30521) (July 20, 1989)."

[QDROphile]

You cannot prevent taxation for the same reason that you cannot prevent taxation by late repayment after a loan is required to be treated as a deemed distribution. Whether or not you can accept payment at this point is an interesting question (I doubt it), but if it is possible, it will be after tax. Loans are treated as taxable. Section 72(p) provides an exception if the 72(p) rules are followed. Failure to pay the loan within the rules (level amortization at least quaterly) causes the loan to fall out of the exception and become taxable.

[FundeK]

The loan policy indicates that the loan will be offset "within a reasonable period of time following the termination of employment". Although the cure period does not really apply here because it is a terminated participant, we usually use the same time frame to determine what is a reasonable period of time.

So, if the participant terminated in Dec 2003 and missed his first payment in Jan 2004, his "cure period" would end on June 2004. If you consider the loan to be taxable on July 1, 2004, he would have had 60 days to rollover funds to maintain the tax deferred status. So, he should have completed the rollover by the end of August. Of course, a 1099-R was never issued to him so he did not know he had a taxable event.

The participant could potentially request a waiver of the 60 day rule from the IRS to allow the rollover. It appears to me that the IRS waives the 60 quite often, and would most likely waive it in this circumstance as well.

Since a loan offset is eligible for rollover (allowing part to maintain tax deferred status), why couldn't you allow him to pay off the loan and thus maintain the tax deferred status?

Another question: What if we consider 1 year to be a reasonable period of time? Then he is still within the window and could pay off the loan.

[QDROphile]

Section 72(p) and the related regulations say the loan amount is taxable because payments were not made in time. See regulation section 1.72(p)-1, Q&A 10 and Q&A 13. If you maintain that the loan is not offset, it would still be taxable as a deemed distribution. One penalty for not paying the loan within the time required by the rules is taxation. The plan can provide for a shorter cure period than specified in the regulations, but no a longer one.

I don't think the rollover rules have anything to do with taxability at this point. The loan is taxable income in 2004.