Can an employee change mind on loan and change to Hardship?

[Guest J Samuelson]

An employee takes a loan and is about to start the repayments(to be withheld from his paycheck) and says he can't afford the repayments and that he took the money out for medical expenses and wants it to be deemed a hardship withdrawal? He signed all the necessary paperwork for the loan prior to the loan being issued. Can he change his mind after the fact? If the payroll department doesn't withhold the necessary amount, can it be deemed a distribution? I don't think so, but wanted to hear other opinions.

[Guest KMcQ]

If the employee could not afford to repay the loan and he/she had not defaulted on the loan yet, there may be grounds to grant a hardship. Especially if the immedciate need was for bona finde medical expenses. Perhaps the employee could qualify for the hardhip, pay off the loan with the hardship money and be where they wanted to be, i.e. free of the loan repayments.

[Guest KMcQ]

If the employee could not afford to repay the loan and he/she had not defaulted on the loan yet, there may be grounds to grant a hardship. Especially if the immedciate need was for bona finde medical expenses. Perhaps the employee could qualify for the hardhip, pay off the loan with the hardship money and be where they wanted to be, i.e. free of the loan repayments.

[MWeddell]

One must take any nontaxable loans from the plan first before the hardship withdrawal request would be valid.

Although the employer can deny a loan request (thereby enabling the participant to then apply for the hardship withdrawal), it sounds like the only grounds would be if the employer knows that the employee has no intention of repaying the loan. This might be hard to do if the employee signed an irrevocable consent to have loan payments withheld from paychecks.

In short, I'd be careful before letting the employee change his mind and get a hardship withdrawal instead of a loan.

[Guest Off_the_record]

MWendell.... I believe you quoted the "safe harbor" rule regarding hardship distributions, in that a hardship distribution can only be given after all plan loans have been taken. The plan may operate under a non-safe harbor and consequently have no such requirement. I must admit that I don't have the code/regs in front of me, but I believe that is correct. However, even if I am not correct, NO ADVERSE CONSEQUENCES WOULD EVER arise from this situation. The odds of this ending up in any audit, and have the agent actually understand, let alone catch this, are astronomical.

[MWeddell]

Responding to Off_the_record:

The requirement that one must take any nontaxable loans before one becomes eligible for a hardship withdrawal applies regardless of which method the plan uses to pass the resources test. See Treas. Reg. 1.401(k)-1(d)(2)(iii)(B)(4). While this language describes the contents of the employee's written representation if the employer chooses to rely on the representation, the flush language after that makes clear that the ability to borrow from the plan on a nontaxable basis is a resource that the employee must first use under the general test.

I would think that checking to see if those who had hardship withdrawals first exhausted their opportunities to take loans would be fairly easy for an IRS agent to catch. The problem can be detected just be looking at a recordkeeping valuation report. The requirement to take a loan first is accurately stated in the 1994 401(k) examination guidelines, although it's not listed as a specific action step. I wouldn't call the odds of being caught "astronomical." In any case, I though JSamuelson was inquiring about what the correct answer was, not the likelihood of being caught if he or his client chooses to violate an IRS regulation.