when plan loan balance is close or equals contributions on file

[Guest beccafaith]

Can someone point me to reference when this situation occurs and how it should be handled?

I have a participant whose defaulted loan balance is pretty close to their total contributions on file. They terminated, left their contributions and left their loan, too. Now, after several reminders, they are withdrawaling their contributions to pay the loan back.

For some reason, in the back of my mind, I thought there was an IRS provision about how you cannot take all of the contributions on file to offset the loan against.

Or, am I getting confused?

Which is totally possible since I have a 3 year old at home which uses the rest of my brain cells up once I get home .

Any thoughts or help is much appreciated.

[E as in ERISA]

What do you mean "withdrawing contributions"? They can get a distribution for the amount of their account balance less the amount of the outstanding loan. If their account balance is $10,000 and their loan is $5,000, then it doesn't much matter whether they have an offset or take the $5,000 and pay off the loan. Either way they're currently taxed on $5,000 and they have $5,000 in the plan, right?

[Guest beccafaith]

They have now officially terminated and are withdrawing their funds. Their loan balance come out to about 99% of the their contribution balance. For example, 10,000 less the 9,900 for loan, which leaves them the 100.00 they will be eligible to receive.

They quit their job years ago, but never withdrew their funds for whatever reason.

They've been notified several times about their outstanding loan on file and how it is accruing interest.

The latest notice, I guess, got their attention and they realize that the loan is exceeding the contributions they left on file and are now acting upon it.

They have decided to withdrawal their funds and have the loan offset against them.

[E as in ERISA]

Well, they should only be able to withdraw $100, not $10,000. So they won't be able to pay the loan back with the $100. They'll just get $100, get the loan wiped off the books, and be taxed on $10,000.

[Demosthenes]

If I'm reading this correctly, you are contending that the accruing interest is absorbing the participants remaining dollar balance?

e.g Participant has a 10k balance, takes a 5k loan, still has 5k in cash in the plan. They then terminate. Interetst on the loan accrues at 10%/year. In 10 years the loan now has 5k principle, 5k in accrued interest. 5k in accrued interest wipes out 5k in remaining cash.

Is that the theory?

[Guest beccafaith]

Yes to both of you.

Yes E, this is exactly what is taking place. They are only walking away with the $100 and the loan is wiped out at this point.

Demo, you are correct in that theory.

As I said, and I may be mistaken, this is exactly what is happening, but for some reason I thought there was an IRS reg out there that stated you could not wipe out a participant's account to satisfy a loan.

That is all I am asking. I already agree with the two of you and that is exactly what has happened.

[stephen]

Perhaps we should get all of the facts before responding. I find it hard to believe that a participant could have a $10,000 balance $9,900 of which is an outstanding loan balance and only $100 is cash in the plan without having some previous distribution(s) or loan default.

If in fact the loan balance has already defaulted and the balance is $100 cash and $9,900 in loan balance it seems that they will get a distribution of $100 and be taxed on just this amount as the loan has already been defaulted and thus the participant has already been taxed on the loan portion of their balance.

[Guest beccafaith]

Stephen,

Why would you find it hard to believe that a participant would leave employment 10 years ago with a loan balance? That is one of the problems with borrowing against retirement plans, members do it all the time. I have heard many excuses in my area of why they leave loan balances, i.e., I forgot about it, I didn't think once I quit I had to pay it back, I didn't know how to pay it, I borrowed it when I was married and now I'm divorced, my spouse made me do it, etc....the list goes on and on. To beat it all when I notify them several times about it, I hear, "well, I just pitch your letters in the trash can."

He is considered in default; however, he was never deemed. Why? I have no idea, I only took the plan over 18 months ago. I cannot go in and deem him in 2005 for a default that occurred in 1995. He received no taxables consequences on it in 1995, no 1099 was issued.

However, when he goes to withdrawal his money, I do have to offset the outstanding loan balance and he will be taxed on it this year.

[E as in ERISA]

I think that proposed regulations were first issued in late 1995 and then re-issued in about 1988 and then finalized in 2000. I don't think a lot of plans took action in the late 90s.

[Guest beccafaith]

You are absolutely right E.

[stephen]

If the plan is never going to default the loan why should the participant take a distribution from the plan? ( Perhaps because the plan has a doucment or loan provisions that say it must be defaulted after x months of no payments. )

It seems to me the recordkeeper from 1995-2000 did the participant wrong by not defaulting the loan at that time and now the participant is having to pay (literally) for past errors.

By the sounds of it I may be in the minority on this one...

[Guest beccafaith]

I concur with you Stephen; however, just because a loan is defaulted, doesn't mean it is paid in full. There is a misconception that being deemed with a 1099-R means your loan at that point in time is paid in full.

Also, guidelines are set forth in the initial loan packet spelling out in detail what transpires with these loans. A whole area is devoted to defaults along with examples that specifically outlines what happens to their contributions when there loan is left unpaid. I even make them initial every page of the document, along with signatures, then when it comes to the default piece, I even have them initial 2 extra places that they have read this information and understand it.

I can deem someone this year and produce a 1099-R on it. I can notify them 4 times a year for 10 years they have an outstanding loan; however, if they voluntarily choose not to pay it, I cannot force them.

[stephen]

I can deem someone this year and produce a 1099-R on it. I can notify them 4 times a year for 10 years they have an outstanding loan; however, if they voluntarily choose not to pay it, I cannot force them.

But if you have deemed the distribution and given them a 1099 on it why would you then make them pay taxes again on this amount when they finally take a distribution? Wouldn't you offset their distribution by the deemed amount of the loan? Do you know that this loan was never reported on a 1099 before?

I know that submitting a 1099 does not mean that the loan has not been paid nor does the loan have to be repaid but to tax them twice on the loan portion of the distribution just seems wrong.

[jsb]

I'm new to loans so just curious.

Demo, the interest accrues, but wouldn't it be as a memo amount that needs to be repaid to cure the default, rather than as a charge against the remaining cash balance in the account? How can accruing interest that is OWED TO the account wipe out money that is already IN the account?

How can $100 payout be correct?

eg. $10K - $5K loan = $5K cash in account (which never grows?)

Loan defaults and accrues interest and Part now owes $9.9K to cure. $5K cash still in account. (OK, it grew until early 2000, then crashed with the rest of the market, but is now back up to $5K.)

Part CURES the default by paying $9.9K into the account.

$9.9K + $5K = $14.9K

Now wants to close, so you send total balance $14.9K.

Wait a minute, I thought we were only going to pay out $100 because of the default? But if we add the $9.9K default cure to the $100, there is only $10K available, not $14.9K. Is this 401(K) math? Hmmmm... Did loan fees eat up the other $4.9K?

Just trying to understand....

[E as in ERISA]

How about the participant contributed $10,000 in the early nineties, took a $5,000 loan. The other $5,000 was invested in a high risk investment that tanked and NEVER recovered. The loan grew to $9,900. The poor investment is worth only $100. She keeps talking in terms of "contributions" as opposed to account balance. So I was assuming that somehow the participant thinks that they should get their $10,000 they contributed back. Or at least the other $5,000. And that may not be the case.

[Bird]

Perhaps we should get all of the facts before responding. I find it hard to believe that a participant could have a $10,000 balance $9,900 of which is an outstanding loan balance and only $100 is cash in the plan without having some previous distribution(s) or loan default.

  Stephen,

Why would you find it hard to believe that a participant would leave employment 10 years ago with a loan balance? That is one of the problems with borrowing against retirement plans, members do it all the time. I have heard many excuses in my area of why they leave loan balances, i.e., I forgot about it, I didn't think once I quit I had to pay it back, I didn't know how to pay it, I borrowed it when I was married and now I'm divorced, my spouse made me do it, etc....the list goes on and on. To beat it all when I notify them several times about it, I hear, "well, I just pitch your letters in the trash can."

Your response does not address Stephen's concern. Something doesn't sound right.

Is this a self-directed or pooled plan?

If it's pooled, is the loan part of the pooled account or does it effectively become a self-directed account?

Could you describe the progression of the participant's total account balance and loan balance since you've handled the plan?

[Demosthenes]

If this is a defined contribution plan where you have made a loan of the participant's vested interest to the participant, the operation of the loans after default, and the impact of that loan on the remaining vested balance, indicates a serious defect in the Plan's operation.

My advice is to engage ERISA counsel immediately.

[Archimage]

Just to add to what Demosthenes is saying, most plans offset loans when a participant reaches a distributable event such as a termination. At this point the loan is offset from the participant's account and completely wiped off the books. There is no more accrued interest at that point. I would go back and look at the plan's loan policy to see what the provisions state. The situation you are stating is very uncommon (in my experience anyway).

[Guest beccafaith]

Okay I'm ending my discussion. We have totally gotten off track of what I initially asked.

If you want to email me about it, fine, otherwise, I got my answer from E in the very beginning.

[stephen]

beccafaith,

I do not think we have gotten totally off track of what was originally asked. I do think it will be a shame if the participant receives a $100 distribution and has to pay taxes on $10,000 if it is not neccessary. I woul dnot want to be one trying to explain to them that they owe approximately $2,800 in taxes (assuming a 28% tax bracket) on their $100 distribution.

Best of luck to you in dealing with this situation.

[Guest beccafaith]

FYI Stephen.........I have already approached my legal counsel and compliance officer of this situation.