Loan Payments

[Guest CathyS]

We have a debate regarding loan payments made via payroll deduction that I hope to get some guidance on before advising client. Loan policy states as a term that, " If the participant is currently employed by the Employer, the Plan Administrator will require the participant receiving a loan from the Plan to enter into a payroll deduction agreement to repay the loan. If the participant is not currently employed by the Employer, the Plan Administrator may require additional collateral for the loan."

The participant has asked the employer to stop withholding loan payments from the paycheck, basically with the intent not to pay it back. What is the employer able to do? Can the employer require the employee to have the payments withheld or do they abide by the participant's request, which will result in a deemed distribution?

[wsp]

If plan sponsor (employer) allows the stoppage of the loan payments they would, in effect, be allowing an impermissable in-service distribution. And, if you allowed it for one you'd have to allow it for all. The loan policy would have to be changed to allow for elective default.

End result would be prohibited transaction issues and more likely due to the impermissable in-service distribution issues a plan disqualification issue.

Don't allow it.

[masteff]

Be careful about your state's payroll laws. Some states require that if EE puts in writing to stop a deduction such as this, then you have to stop it regardless (it's not truly mandatory like withholding or a garnishment). Then the loan simply defaults per normal procedure (end of quarter after quarter of last payment). If in doubt about payroll laws, check w/ local counsel.

[Guest mjb]

Q what does the plan require as the method of repayment for loans? Well drafted plans require that the employee repay loans by salary deduction and include a provision in the note to prevent the employee from turning the loan into an impermissible in service distribution. State payroll laws are preempted because they intefer with the plan funding provisions and could effect plan's qualified status if plan permitted loans which were really distributions. If the plan admin is afraid of violating state payroll laws by requiring payroll withholding then the plan should not offer loans.

[Bird]

I think that the reasoning behind requiring payroll deductions for loan payments is administrative simplicity, NOT to prevent participants from defaulting. Unless the payroll deduction agreement is irrevocable, which I doubt, I don't see how an employer can prevent an EMPLOYEE (who just happens to be a participant) from changing it.

wsp, do you have any basis for your statements? Following your logic, any loan default would be "an impermissable [sic] in-service distribution." Loans default; it's a fact of plan administration.

[masteff]

Nothing in the regulations mandates that payments be by payroll nor that said payments cannot be stopped. Q&A-4 of the regs says a deemed distribution occurs when the loan fails to meet the requirements of Q&A-3, whether at the time of the loan or after. I would point you to the Example in Q&A-10 of 1.72(p)-1...

Example. (i) On August 1, 2002, a participant has a nonforfeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over 5 years in level monthly installments due at the end of each month. After making all monthly payments due through July 31, 2003, the participant fails to make the payment due on August 31, 2003 or any other monthly payments due thereafter. The plan administrator allows a three-month cure period.

(ii) As a result of the failure to satisfy the requirement that the loan be repaid in level installments pursuant to section 72(p)(2)©, the participant has a deemed distribution on November 30, 2003, which is the last day of the three-month cure period for the August 31, 2003 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 2003. Alternatively, if the plan administrator had allowed a cure period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 2003 equal to $17,282, which is the outstanding balance of the loan at December 31, 2003.

This does not say that the loan was defaulted because the employee violated a deduction agreement, it was defaulted due to non-payment which made it no longer a qualified loan.

[401_4_ever]

I agree with Bird, loans default it's part of life. I don't see a problem with defaulting on a uniform & nondiscriminatory basis if the PA believes he can't pay it off.

[wsp]

I think that the reasoning behind requiring payroll deductions for loan payments is administrative simplicity, NOT to prevent participants from defaulting. Unless the payroll deduction agreement is irrevocable, which I doubt, I don't see how an employer can prevent an EMPLOYEE (who just happens to be a participant) from changing it.

wsp, do you have any basis for your statements? Following your logic, any loan default would be "an impermissable [sic] in-service distribution." Loans default; it's a fact of plan administration.

We are not talking about any loan default. We are talking about a loan default that the plan sponsor is a party to. That's the difference and the reason that you can't allow it to happen.

Treas. Reg §1.72(p))-1, Q&A-3(b) is the source of the whole issue. It says that the loan must be evidenced by a legally enforceable agreement. In this case the legally enforceable agreement says that the loan will be paid via payroll deduction if employed. By signing the document the participant is agreeing to have the loan payment taken via payroll deduction for the loan period. Not that the payments will be made via payroll deduction. The participant does not have the authority to stop the loan payments, since loan payments as a payroll deduction are based on an agreement with the employer. The employer would have to agree to stop the loan payments.

Further, if the employer fails to enforce the loan document or fails to enforce the loan policy then the plan has got a sham loan program. ERISA Regulation Section 2550.408b-1(a)(3) deals with that with the following: "The existence of a participant loan or participant loan program will be determined upon consideration of all relevant facts and circumstances. Thus, for example, the mere presence of a loan document appearing to satisfy the requirements of section 408(b)(1) will not be dispositive of whether a participant loan exists where the subsequent administration of the loan indicates that the parties to the loan agreement did not intend the loan to be repaid". And yes, by allowing it to happen you have turned your program into a sham program because it's only a matter of time before it happens again and again. Then sooner or later you'll have a participant take a loan with no intention of making a single payment. At that point you may as well fold up the tent on your loan program; and depending on who is taking the "loan" it could be your entire plan.

As for the impermissible distribution issue, simply look to 401(k)(2) and (10). Since the participant is still employed and the repayment of a loan is not a reason to allow a hardship, unless the participant is of age or the source of the money allows for inservice distributions, I would say that by not taking the loan payment as the document requires them to do the employer has voluntarily issued a distribution from the plan that is not allowed. Certainly that same employer wouldn't grant a regular distribution under these circumstances so why would this be any different?

Of course it's all moot if the plans sponsor/employer doesn't want to be involved in the process and the loan documents do not state how the loan is to be repaid. Because then the loan isn't being granted on a condition of repayment via payroll deduction but instead on a condition of repayment via check. At that point there is nothing to prevent the employee from failing to write the check and suffering the consequences. But that's not the premise that the OP posted.

[Guest mjb]

I agree w/wsp. Well run plans require that all loan repayments be made by payroll deduction to avoid both adm hassles resulting from default (e.g., tax reporting, notifying employees) as well as potential audit issues discussed in 72p regs. Large multi state corp and their payroll services do not allow employees to cancel payroll withholding. It is to be noted that employees who declare bkcy are no longer allowed to cancel payroll deduction for loan repayments.

[401_4_ever]

Simply because you allow a participant to default a loan due to financial hardship does not actually mean it will happen "time and time again." The PA still has to approve it on a uniform & nondiscriminatory process.

ERISA Regulation Section 2550.408b-1(a)(3) says you have to look at facts on a case by case and leaves open a facts and circumstnaces test to see whether the loan program is a sham program. There is no requirement to simply not default a loan.

"And yes, by allowing it to happen you have turned your program into a sham program because it's only a matter of time before it happens again and again." -- You know that applies everytime? There's no possible PA who would only allow it on demonstrated financial hardship?

"Then sooner or later you'll have a participant take a loan with no intention of making a single payment." In that instance, the PA can simply not agree to default it.

[401_4_ever]

"Large multi state corp and their payroll services do not allow employees to cancel payroll withholding."

I know of a Fortune 100 company that is publicly traded that consistently allows loan defaults if the Participant can show they are financially unable to continue making payments. I'm sure they aren't the only one.

[masteff]

"Large multi state corp and their payroll services do not allow employees to cancel payroll withholding."

I know of a Fortune 100 company that is publicly traded that consistently allows loan defaults if the Participant can show they are financially unable to continue making payments. I'm sure they aren't the only one.

Nope, not the only one... at previous job, we had four 401(k) plans with over $1billion in assets. While we didn't advertise it and even went so far as to actively discourage defaulting, my management explicity determined that if we had such a request in writing, we would have to honor it. And those plans went thru both IRS and DOL audits w/in the last 3 years.

[austin3515]

Let's consider the likely possibility that there are (in my opinion) two correct yet mutually exclusive answers. I for one cannot find a flaw in any of the arguments listed above.

Don't you just love this stuff??

[JanetM]

As I sit here with my plan sponsor fiduciary hat on and am horrifed. We do not allow folks to take loans and then stop making loan payemnts.

Those folks in financial distress don't need the tax or the penalty on top of their debt. That is why Plan loans now receive favorable treatment in bankruptcy.

[Bird]

wsp, the "legally enforceable" agreement part of the regs, IMO, is not so much about forcing a participant to repay but about a consequence for not fulfilling the promise to pay and enforcing it - in this case it's a default.

I agree that a program that consistently permits loans that are consistently defaulted, especially after no or few payments, is a sham program for in-service distributions. And loan programs, and loans, should be monitored to prevent that from happening. But to say that a loan default is not allowed because then it's a violation of the plan's prohibition on in-service distributions is extreme, IMO. I understand the distinction you're making, that the employer is a party to the agreement to withhold by payroll deduction, but as noted earlier, unless it's irrevocable, I think that's an employer/employee relationship and the employer can't forbid the employee from making a change.

[Guest mjb]

I have never understood how allowing an employee to default on a loan helps relieve financial distress since the imputed income is subject to fed, state and the 10% penalty tax which can equal 30% of the loan balance. Employees who default on loans frequently apply for new loans around april 15 to pay the taxes.

[401_4_ever]

I have never understood how allowing an employee to default on a loan helps relieve financial distress since the imputed income is subject to fed, state and the 10% penalty tax which can equal 30% of the loan balance. Employees who default on loans frequently apply for new loans around april 15 to pay the taxes.

My only response to that is the same one; the PA has to look at it on a case by case basis. It is of course possible a loan default would relieve a financial distress. Is it typical? Probably not. But there are situations where it would.

[austin3515]

For example, if its January, your on the verge of foreclosure, you need to buy diapers for your kid, and the taxes associated w/ default are not due for 16 months!!

[wsp]

For example, if its January, your on the verge of foreclosure, you need to buy diapers for your kid, and the taxes associated w/ default are not due for 16 months!!

That doesn't relieve the distress just puts it off for 16 months; likely shorter if it got that far.

Either way the participant is better served if they were given the number for a legitimate credit counseling service then a loan default.

Question though...does the plan's obligation to collect on the debt end with the default?

[401_4_ever]

I generally say no, the plan still has some sort of obligation to collect on the debt, using reasonable efforts. If a participant comes back and wants to pay it off, they can set up an after-tax (not Roth, actual after-tax) source to let them pay it off. Additionally we warn the PA they should be wary before allowing the same participant from taking another loan.