Pay back on loan "not required".

[Guest Melissa Winslow]

I administer a vanilla nonstandardized prototype 401(k) plan which allows for loans. One of the plan participants would like to take a loan. However, this participant has read a book by Charles Givens entitled "Wealth Without Risk". In this book, there is a passage where Mr. Givens indicates that if a participant borrows money from a retirement plan to make a down payment on a home, the participant never has to pay the borrowed money back (paraphrased). He states that this is a "little-known, major opportunity Congress threw into the qualified retirement plan rules". No citation was given. I have not come across this in the reading of the regulations I have done. Can anyone comment on this? Is there a regulation I can be referred to?

[Scuba 401]

I do not think that book is accurate unless there is confusion between what is a loan and what might be a hardship. However, if the loan is for the "purchase of a principal residence, the five year repayment period is not applicable.

[jkharvey]

If the participant takes a loan and never makes repayments, the participant is in default and has a deemed distribution. (See 72P regulations, I think they are proposed regs.) The participant is still responsible for repaying a loan treated as a "deemed distribution".

[Guest Phil L]

Since most plans require repayment by payroll deduction, MR. Givens big "loophole" is pretty much nonexistent. Once the employee signs the forms to agree to repay via payroll deduction, the company will continue taking the loan repayment out of the employee's check, even if the employee doesn't want that to continue.

[richard]

Notice that no citation was provided in Mr. Givens' book!

[John A]

Once the loan has been treated as a deemed distribution (and assuming that payroll deduction is not used for the particular plan), what further consequences does a participant face if repayment is never made?

If a participant really just wants a taxable distribution (and again assuming the plan has not been set up to repay loans by payroll deduction), does taking a loan and refusing to make payments meet the objective? It seems like the participant should face some type of further penalty, but I am not aware of any.

[Guest CLKeown]

I agree with Scuba 401.

The only change if the loan is for the purchase of a primary residence (primary being a key word also) is that the 5 year repayment terms are waived and repayment terms can be extended. I believe that the terms can be extended to 15 years, but you should check on that number.

Carole

[Guest]

lets see, if ee is not 59 1/2 he/she will socked with a 10% early withdrawal penalty. OUCH.

At tax time he/she will have to pay taxes on the amount of distribution. OUCH

so much for getting a loan.

Taking a hardship is a different matter, because there are no monthly loan payments - obviously. hardships are allowable for FIRST time home purchases, but if plan allows loans, then loans are suppose to be taken first in the pecking order.

My understanding there is still 20% withholding except on hardship from deferral.

you also can't defer for a year. Doesn't sound like a good idea to me.

The only advantage I can think of to taking the loan is you pay back the interest to yourself, but even then you get no tax deduction. And your earnings are greatly reduced - e.g. take a look at what the stock market has done recently. Current mortgage rate around 9% - are your earnings more than 9%????

[Alonzo]

I'm hoping the plan in this case makes people repay by payroll deduction. The administrator then can point to the provisions of the plan and say, "can't give you a loan unless you agree to payroll deduction."

Problem is, that if you give a loan to a participant who you know to have no intention of paying it back, you arguably have engaged in a prohibited transaction. (Such a loan would not be "adequately secured") That's a 15% excise tax on the employer, which becomes a 100% tax if it is not corrected. While this is something that may be hard to pick up on audit, you should not allow -- on general principle -- to allow participants to "get around" the rules of the plan. For one thing, the employee may very well tell others about the neat trick he pulled, and you'll be faced a lot of other employees pulling the same kind of maneuvers. Your 5500s (if done properly) will start to show the large number of loan defaults, and DoL investigators will become interested.

[Guest KSS]

To take this discussion a step further, let's say that a participant received a plan loan several years ago but the plan has not enforced the repayment requirement. Accordingly, the plan has not issued a Form 1099R, either, but now would like to "correct" the outstanding defaulted loan. How should the plan report the deemed distribution? If the participant defaulted on the loan in 1993 but the plan did not issue a 1099R for that year (or any subsequent year) to report the deemed distribution, may the plan issue a 1099R for 1993, or is that year closed? Do other options exist? Could the plan issue a 1099R for 2000 (the year of correction)? Thanks for your insight.

[KJohnson]

I agree that there cannot be an "understanding" that a loan will not be repaid or there is a prohibited transaction.

Also, there are differences between when a "deemed distribution" happens (upon default) and when the Plan can actually "collect" the defaulted loan by offsetting the loan against the account balance. Typically an offset cannot happen until a distribution event takes place (i.e. termination of employment etc.). I believe that the IRS and DOL have both stated informally that a Plan cannot simply "stand back" and wait for a distribution event, but rather must take affirmative action to collect on the loan. Using plan assets to pursue collection when there is an "automatic" collection mechanism as soon as the employee is eligible for a distribution has always seemed counterproductive to me. How far your "collection efforts" must go is also unclear to me.

[John A]

I'm still unclear on what consequences there are to the participant (and it stilll seems like there should be some) after the participant is hit with the taxation issues for the deemed distribution. I'm thinking of a situation in which the plan sponsor did proper due diligence, but the participant, unknown to the plan sponsor, never had any intention of paying back the loan. Could the employer implement payroll deduction at this point even if it had not been in place previously? If the employer can force the participant to still pay back the loan, then the consequence seems just. If the participant manages to not repay the loan at all, it still seems as if there is no further consequence to the participant and the participant has essentially gotten away with getting a distribution that should not have been allowed.

[davef]

Many states have wage-hour laws that prohibit an employer from withholding from a person's pay without consent. If a participant changes his/her mind about having the loan repaid through salary deduction, is this a way to default on the loan?

Regarding the deemed distribution issue, could the taxes be avoided if a loan is taken from pre-87 grandfathered employee contributions? Wouldn't the deemed distribution be a non-taxable event? If the deemed distribution was not taxed, then the 10% penalty would not apply as well. I realize that this would not be a common situation, but it could happen. Also, this does not avoid any PT issues mentioned above.

[KJohnson]

The status of those wage and hour laws as they apply to employee benefit plans is a real question. DOL has stated that similar type laws are preempted. This is a real question for use of negative elections.

[KIP KRAUS]

Melissa:

Why not see if you can find a a way to contact Charles Givens and ask him how his theory works. In fact, I might try to contact him and see if he can get me back the illegal 10% (yes folks, I think it's illegal) penalty I had to pay to use my 401(k) money when I was unemployed for 16 months.

[Brenda Wren]

Givens has been sued many times for his so-called "advice". Last I heard he was battling cancer. I always understood that if you didn't pay back your loan, interest continued to accrue until a distributable event occurred. Doesn't sound like a loophole to me!