In-Service Distribution with Outstanding Loan

[Randy Watson]

Could a plan, such as a defined benefit plan or a defined contribution plan other than a participant directed account plan, permit a participant to take an in-service distribution of their entire account balance, including the participant's outstanding loan balance (which is treated as an investment)? The participant would continue to pay that loan off through payroll deductions.

Assume all loan limitations were satisfied at the time the loan was made.

[QDROphile]

A loan cannot remain outstanding in the hands of the borrower. The loan ceases to exist by operation of law. The IRS overlooked this legal nicety in the rules about loan rollovers, but it was a very practical error that no one will challenge. A loan that rests with the borrower is another matter.

[Randy Watson]

A loan cannot remain outstanding in the hands of the borrower. The loan ceases to exist by operation of law. The IRS overlooked this legal nicety in the rules about loan rollovers, but it was a very practical error that no one will challenge. A loan that rests with the borrower is another matter.

So there's nothing in the Code or ERISA that prohibits this?

[ESOP Guy]

I am going to answer your question with a question. ( I think I understand your questions)

What happens in the following situation?

The person takes the 100% in-service distribution spends the money and then quits.

How is the plan going to collect the remaining loan balance, there is no longer any payroll deductions?

If it doesn’t collect everyone else in the plan takes a hit.

This doesn’t sound like the plan’s Fiduciary is doing his job.

There is no rule related to participant loans that stops this idea, but Fiduciaries are required to be prudent investors of the plan's assets and this doesn't sound very prudent.

Edit fixed typos

[Randy Watson]

I am going to answer your question with a question. ( I think I understand your questions)

What happens in the following situation?

The person takes the 100% in-service distribution spends the money and then quits.

How is the plan going to collect the remaining loan balance, there is no longer any payroll deductions?

If it doesn’t collect everyone else in the plan takes a hit.

This doesn’t sound like the plan’s Fiduciary is doing his job.

There is no rule related to participant loans that stops this idea, but Fiduciaries are required to be prudent investors of the plan's assets and this doesn't sound very prudent.

Edit fixed typos

That's a good point. Are you saying that the only snag in this is that the fiduciary must act prudently? In my proposed set of facts we have a participant who is taking an in-service distribution and will continue to make loan payments through payroll deduction. The risk imposed on other participants is not as great (or possibly nonexistent in a DB plan where the employer is solely responsible for funding). Any thoughts?

[Bird]

Could a plan, such as a defined benefit plan or a defined contribution plan other than a participant directed account plan, permit a participant to take an in-service distribution of their entire account balance, including the participant's outstanding loan balance (which is treated as an investment)? The participant would continue to pay that loan off through payroll deductions.

No.

I believe the correct reasoning for this is a) a loan to a participant is a prohibited transaction, b) there is an exemption for participant loans meeting certain requirements, c) you blow the exemption when the participant holds a note that doesn't meet the requirements, and it would in fact fail to meet the requirements, the 50% rule being the first one that comes to mind.

[Randy Watson]

Could a plan, such as a defined benefit plan or a defined contribution plan other than a participant directed account plan, permit a participant to take an in-service distribution of their entire account balance, including the participant's outstanding loan balance (which is treated as an investment)? The participant would continue to pay that loan off through payroll deductions.

No.

I believe the correct reasoning for this is a) a loan to a participant is a prohibited transaction, b) there is an exemption for participant loans meeting certain requirements, c) you blow the exemption when the participant holds a note that doesn't meet the requirements, and it would in fact fail to meet the requirements, the 50% rule being the first one that comes to mind.

It was my understanding that the 50% rule had to be satisfied at the time the loan was made.

[ESOP Guy]

Bird:

I am happy to be told I am wrong, but doesn’t the 50% rule only apply when the loan is made? (Assume a participant directed 401(k) plan) For example, if one had a $20k balance and took out a $5k loan, and then took out a $12k in-service distribution the loan is still fine.

However, I did go back and looked at the DOL regs and here they are:

§ 2550.408b-1 General statutory exemption for loans to plan participants and beneficiaries who are parties in interest with respect to the plan.

(a)(1) In general. Section 408(b)(1) of the Employee Retirement Income Security Act of 1974 (the Act or ERISA) exempts from the prohibitions of section 406(a), 406(b)(1) and 406(b)(2) loans by a plan to parties in interest who are participants or beneficiaries of the plan, provided that such loans:

(i) Are available to all such participants and beneficiaries on a reasonably equivalent basis;

(ii) Are not made available to highly compensated employees, officers or shareholders in an amount greater than the amount made available to other employees;

(iii) Are made in accordance with specific provisions regarding such loans set forth in the plan;

(iv) Bear a reasonable rate of interest; and

(v) Are adequately secured.

I don’t see how this loan is adequately secured. Even if the 50% rules only applies when the loan is taken out it appears this rule applies the whole time the loan exists. So, I agree with Bird it is a PT, but for slightly different reasons.

For what it is worth I don’t think a DB fiduciary can get out of being a prudent investor just because the employer, who may be the same person, will be the one that pays. But I am not a DB expert by any means. While the same person might wear both the “plan sponsor” hat and “plan fiduciary” hat they are two different jobs and both need to be done right. So I don’t think the fact the risk is low because the sponsor will in the end be the one that pays works either.

[Randy Watson]

How about a situtation where the market tanks and the assets securing the loan are valued well under the 50% threshold? Or what about a QDRO awarding 100% of a participant's account to an alternate payee? Would those lead to PTs?

[mbozek]

Could a plan, such as a defined benefit plan or a defined contribution plan other than a participant directed account plan, permit a participant to take an in-service distribution of their entire account balance, including the participant's outstanding loan balance (which is treated as an investment)? The participant would continue to pay that loan off through payroll deductions.

Assume all loan limitations were satisfied at the time the loan was made.

I dont understand the need to distribute the loan before it is paid off if the participant remains in service. Under the regs the loan is an asset of the plan and must remain in the custody of the trustee if loan payments continue to be made to the participant's account. If the loan is distributed the payments are no longer made to a plan asset and cannot be included in the participants account balance to reduce the taxable amount of the outstanding loan. Why not retain the loan as a plan asset and allow the participant to continue to payoff the loan through payroll deduction. Anyway, in a DB plan inservice distributions cannot occur before 62. Also in a DB plan what is the participant's plan interest that is security for the loan since there is no individual account?

[Bird]

I was a little worried about the 50% rule taking this down the wrong path and I retract that reasoning for it being a PT. The bottom line is that if the loan is distributed, then it's no longer a participant loan meeting those requirements - (in)adequate security is a fine reason.