Hardship distrib OK after half of account pledged as security for a lo

[Guest LARRY]

If a $1000 plan loan is taken out from a 401 (k) account by a participant with a $2000 vested balance and the account is used as collateral, can the same participant with a legitimate hardship of $2000 request the loan collateral of $1000 still in the plan be paid to him under the hardship rules?????

[Guest Robin Vatalaro]

Sorry I can't answer your question, but I hope someone does; I have this issue come up all the time. Some TPA firms I'm familiar w/ do not allow the hardship in the facts you describe. Some others I'm familiar w/ do.

I have done a little looking and haven't ever been able to find anything definitive on this issue.

On one hand, if you process the loan, and the participant is not also requesting a hardship, what do you do if a market loss causes the balance of the account to fall below $1,000? Is there a problem? If there is a problem, how would you correct it? You can't just easily dump more $ into the account due to restrictions w/ qualified plans.

I am very familiar w/ the 50%/$50,000 rule, but I do find it interesting that the IRS requires collateral considering not much happens if the loan is not repaid except default and a 1099R. There seems to be little point to the collateral unless the IRS is simply trying to restrict how much one can take in the way of a loan for other reasons.

My opinion has always been that combo loan and hardship is allowed even though the hardship takes the account below 50%. But this is simply my interpretation which doesn't necessarily mean much in the big scheme of things, especially if anyone out there has a specific cite or authority as to why a combo loan/hardship would not be allowed.

I know I haven't been much help here, but we've started a dialogue. I'm very curious to hear other people's opinions on this issue.

[Guest Robin Vatalaro]

Forgot this in my first message. Don't forget that there are normally significant restrictions on the type of money that can be removed from an account for a hardship. Normally only elective contributions can be removed, but the document will dictate. Deferral earnings also cannot be removed unless earned prior to 1/1/89 (I'm pretty sure that's the date w/o looking it up).

This begs the question, if you can process a hardship after a loan that would deplete the account balance beyond the 50% collateral, can you "track" the account such that you are "pulling" the loan out of deferral earnings first, then out of other sources of money that cannot be pulled for hardship under the terms of the applicable plan document (e.g. profit sharing dollars, etc).

Pulling the loan proceeds in this fashion leaves the max available for hardship. Whereas if you process the loan from deferral contributions, for example, you no longer have those deferrals from which to pull a hardship. This is another issue I hear many TPA's wrestle with.

What is everyone out there doing?

[david shipp]

It is important to note that the collateral issue for plan loans is a DOL requirement. ERISA 408(B)(1) requires that a participant loan be adequately secured (among other things) in order to avoid being a prohibited transaction.

Under the DOL regs., a loan is adequately secured if it is collateralized by no more than 50% of the account balance determined immediately after the origination of the loan. As a result, subsequent decreases in account value will not affect the adequacy of the security for the initial loan, but can affect the availability of subsequent loans.

If 50% of the account balance is used for collateral, the remaining 50% is available for hardship withdrawal or any other distribution permitted by the plan. See 17 BNA 1718, in which DOL's Deborah Hobbs is quoted as saying "Under the terms of the regulation, no more than 50% of the participant's vested accrued benefit may be considered as security for the loan, . . . but nothing in the regulation would preclude the remainder of the present value . . . from being available for a hardship distribution."

Note, however, that some plans routinely take a 100% collateral interest in a participant's account balance even though the loan is limited to 50%. In that case, it might be difficult to argue that the "excess" account balance is available for distribution since it is part of the collateral pledged for the loan. Such loan procedures might be modified to reduce the collateral interest to 50%.

[Guest ERead]

Lets look at the hardship and loan together. Most hardship provision that I have seen require that the hardship be proven as the participants last resort to avoid "the hardship". So - they would have to apply for a loan from the plan prior to receiving the hardship. What then becomes of the loan - does the loan committee approve the loan? I would suggest they deny the loan based on the prior knowledge that the participant must apply before taking a hardship. I would consider that a bad investment choice by the trustee. Any other thoughts here?

Also - the loan itself could create a hardship - in the case where the loan is granted for a primary residence......

I agree that the loan amount is deducted from the account balance prior to determining the hardship amount available.

The 50%/$50,000 rule only applies to the balance at the time the participant takes the loan - therefore market changes would not cause a problem there.

[Guest Beavis]

My experience/opinion is with David. Though on the surface it seems a little agressive, I don't think that there is anything in the regs to prohibit allowing the hardship after the loan.

If the IRS didn't want this to happen, they've had ample time to address the issue.

[QDROphile]

To ERead: You solve your problem by having a plan provision that requires the borrower to establish an intention and a reasonably certain capacity to repay the loan when due. When the participant tries to borrow (as is required under the plan's hardship rules) the administrator rejects the application because the participant is so distressed as to call in question that the loan will be repaid. This opens the door for the entire amount to be withdrawn under the hardship provisions. But be careful. Each loan has to meet the standard (which will ususally be easy if the plan gets an assignment of pay). Such an approach causes problems if you try to go with one of the big administrators who uses automated loan origination. They do not have a place in the system for a thoughtful review of a loan application - they just go by numbers in the account. You will violate the requirement for a demonstration if the loan process is automatic.

[LCARUSI]

I agree with Beavis. I don't think there is any reason why you could not grant the hardship after the loan. Furthermore, if the participant satisfies the plan requirements for a hardship withdrawal, I don't think the sponsor could deny it (using the loan issue as a basis for denial).

[Guest Paul Hinderegger]

Lets throw one more wrinkle into this situation. I agree with Dave and others that a loan is adequately secured if it is collateralized by no more than 50% of the account balance determined immediately after the origination of the loan.

My question is - - what is the "origination date" of the loan. For example, under a daily valuation environment, is the origination date:

1) The date on which a participant requests a loan through a VRU or Web Site. At that point, the amount of the loan, repayment period, interest rate and first payment date are known.

2) The date on which the participants funds are sold to generate the loan proceeds.

3) The date the check is cut.

Determining the "origination date" is especially important during these wild market fluctuations we have experienced recently. A participant may be adequately secured on the date they request a loan, but by the time the check is cut, the participant's security may have dropped below the 50% limit.

Any comments would be greatly appreciated.

[LCARUSI]

Paul, I think you have some flexibility here. I think it would be okay to use either of your approaches (1) or (2). You would want to use the same procedure consistently for everyone and incorporate it into the Loan Policy for the Plan.