In-Service Withdrawal Following Max Loan

[kevind2010]

Say a participant takes maximum loan of 50% of their vested balance. A few months later, they request an in-service withdrawal having met the plan's age 59 1/2 requirement. The investment provider is limiting the participant's withdrawal amount such that their remaining balance after the withdrawal is still equal to the remaining outstanding loan balance, stating the participant must maintain the collateral on the existing loan balance. We do not agree with this. The 50% limit should only apply the day the loan is originally requested. A participant should be able to take an in-service withdrawal assuming they have met the plan requirements in any amount that they want, regardless of their current loan balance. Does anyone agree/disagree?

[K2retire]

I agree with you. I've seen record keepers write, and have the client sign off, on their own loan policies that conflict with the plan's loan policy. I've also seen call center staff give wrong information.

Start by asking the record keeper to produce any documentation they have for this "rule".

[ESOP Guy]

For one thing the loan is its own collateral in my mind. If the person didn't pay a cent on the loan and simply defaulted what would a plan do? It would reduce the person's account balance by the value of the loan. It wouldn't take the the cash in his account and pay the loan? Who would it make the payment to with the cash?

Also, the regulations are clear you only have to meet the 50% rule on the day the loan is taken. I believe Sal's book has a good discussion of this.

[QDROphile]

The answer should be in the plan documents, which would include written loan policies. The plan can be more restrictive than the law.

[MoJo]

Are you saying that the recordkeeper is insisting that the account balance include both the loan and sufficient other assets equal to the amount of the loan? That is clearly wrong (for the reasons the other posters have indicated) - but there may be a communications issue here. I've had the same discussion with record keepers before - and had to clearly explain to them that 1) the loan itself is an asset of the trust; 2) unless the loan is actually distributed as part of the in-service distribution, it remains an asset of the trust; and 3) immediately after the in-service distribution of non-loan assets, the participant's account still has a positive value equal to the outstanding balance on the loan.

It is amazing how many people don't think of a "loan" as just another investment option selected by the participant. They somehow think that a loan "removes" assets from the trust. The loan removes cash from the trust, replacing it with a "note" (which is just a piece of (virtual) paper - but so is a stiock certificate or a unit in a mutual fund).

Sorry to be so simplistic and rant - but I've experienced the same frustration. If they don't understand, there are plenty of record keepers who do....

[ETA Consulting LLC]

I think ESOP and QDRO has made two interesting points to be considered. In order to make sense of these rule, you should use the context during the time those rules were first written (pre-daily valuation). Back in the balanced forward days, this was the rule because investment values changed. Also, during that time, documents were often written to restrict any distribution from the plan prior to paying off the outstanding loan balance (this is QDROs point). During balance forward days, this was necessary in order to protect the other plan participants from the loan recipients failure to pay.

ESOPs point is that in a daily plan, this is taken care of up-front since you are actually distributing cash directly from the loan recipient's account in order to fund the loan. Should he default, it has no impact on any other participant's accrued benefit under the plan (and become entirely a tax issue for that loan recipient). Under the current daily rules (the notion of 50% doesn't add any logic, but has merely been a rule since the balance forward days).

Good Luck!

[Gadgetfreak]

I agree with everyone here that the 50% rule only applies at the time of the loan but I have a related question which is how I ended up on this thread, An active employee/participant has a $47k outstanding loan balance. He is eligible for an in-service withdrawal of $100k. I don't see why that is not allowed. But here is where I am confused. He "wants" to default on his loan. I am not sure participant's (or the Employer for that matter) can choose to simply say "I want to default". My understanding is that there is a payroll agreement at the time of the loan to state that payments will continue as long as there is payroll.

But what if he "wants" to? Whose responsibility is it to do the payroll deductions and what are the consequences for failure to do it? The participant is the owner. He is OK with a default (can't do an offset). I want to tell him that the Employer is obligated to continue repayments and it is a "violation" if the Employer doesn't. But what, exactly, is the violation? And, if the participant is willing to be taxed anyway, what "punishment" does he get for stopping payments?

[K2retire]

Presumably he signed a note agreeing to repay the loan along with the payroll agreement. That is a legally enforceable obligation that the plan trustee is supposed to pursue. (Is your participant also the trustee?) On the other hand, if he instructs payroll to stop withholding, they are probably required to follow that direction. In which case, the loan would become a deemed distribution, but remain on the books. Depending on the plan's loan policy, the defaulted loan might prevent any future loans to this individual.

[masteff]

The question of deliberately defaulting a loan has been kicked around before.

Click at the top to go back to the main message board page, then use the search box using: +loan +default +payroll (the plus sign forces it to find that word) That won't get all of the prior threads but will get you started. You could also try +loan +default +preemption since some of the debate goes into state payroll laws and ERISA preemption.

Basically some think the participant can deliberately stop making payments while others say they can't. The plan document, plan loan rules, and the loan paperwork may have some bearing. To the best of my memory, no one has come up with a definitive answer (except in cases where the doc, rules or paperwork addressed it). So the best that can be said is: yes it's allowed by some plan sponsors (which doesn't mean it's right or wrong).

[Gadgetfreak]

I checked the FTW Doc and I don't see any language that discusses either line of reasoning. TAG has stated to me that it is a violation on the Sponsor if they fail to withhold loan payment.

[QDROphile]

It is not a matter for plan sponsors, it is a matter for plan administrators. Plan administrators are responsible for plan assets and loans are plan assets. In order to make a loan, the plan administrator is required to believe that the loan will be repaid. The payroll deduction feature is very comforting in suport of that determination, but it is worth much less if the employee may elect out. If the arrangement is optional with the employee and is terminated, the plan administrator will them be faced with whether or not to enforce the loan by other means, as would any creditor. That will not be a very comnfortable decision and enforcement is not a fun process. The plan is owed money; the plan administrator cannot lightly walk away, although the prudent decison may be that is is not worth extraordinary efforts to collect. Better not to be in that position in the first place by allowing easy escape from the payroll deduction.

[BG5150]

I would venture that allowing people to stop on their own could be considered a circumvention of some in-service withdrawal rules.

Say I'm 45 and I take a $30,000 loan from my one-and-only plan account, 401(k). Then immediately I say, "Whoa. Stop the payments, please." I just had what amounts to an in-service withdrawal.

[masteff]

It is not a matter for plan sponsors, it is a matter for plan administrators.

Touche.

[K2retire]

I agree with all of the reasons given for not stopping the payments. But I thought I had read that some state laws prohibit continuing a payroll deduction (other than those required by a court order) after the employee has requested that it stop.

[Guest wickedp1]

How about if a participant is 59 1/2, eligible for an in-service withdrawal, and wants to consider their loan as taxable income? Can they then "default" the loan this way, since their account can be considered immediately distributable per the plan in-service terms?

[ETA Consulting LLC]

Sure, there is no reason they wouldn't be able to do this. Keep in mind that a loan id deemed distributed only in the absent of a distributable event. If the participant is eligible for a distribution, then it may merely take the outstanding loan balance as a taxable distribution.

[QDROphile]

Should be concerned with a plan administrator that simply allowed the particpant to elect to default? The loan was issued with the understanding that it would be paid. That understanding is based in part on a payment mechanism, such as payroll deduction. The repayment expectation and terms behind it are part of the loan assset. The plan administrator has responsibilities with respect to that asset. I do not think the plan administrator can turn its back and allow default without consideration of reasonable actions for collection. For example, payroll deduction authorization should be irrevocable.

[ESOP Guy]

Should be concerned with a plan administrator that simply allowed the particpant to elect to default? The loan was issued with the understanding that it would be paid. That understanding is based in part on a payment mechanism, such as payroll deduction. The repayment expectation and terms behind it are part of the loan assset. The plan administrator has responsibilities with respect to that asset. I do not think the plan administrator can turn its back and allow default without consideration of reasonable actions for collection. For example, payroll deduction authorization should be irrevocable.

While I understand QDRO's concerns would their be less if the questions were asked this way?

Can a participant ask for an in-service distribution that includes nothing but the loan in kind?

My guess less difficult would be a 100% in-service request since the person isn't selecting the asset be distributed. If the in-service distribution is 100% of the account balance then the loan is merely distributed as part of the payment.

[Guest wickedp1]

I agree with ERISAtoolkit..... I also posed this question to TAG, and they stated that if the account is immediately distributable (eligible for distribution of an inservice withdrawal at age 59 1/2 per the plan's document), a participant may take the loan as a distribution, realizing the outstanding loan balance as taxable income.

The game would definitely change if the participant was under the in-service age as specified in the plan's document, or if in-service withdrawals were not allowed.

[QDROphile]

The plan loan secures itself and a participant should not be able to withdraw amounts that seure a plan loan. This is all part of the principle that plan loans are supposed to be repaid and a participant cannot turn a loan into a distribution. If it were so easy, then the plan would not meet the rules that restrict in-service distributions.

I realize that the "loan secures itself" and "amounts that secure a plan loan" are quaint notions that do not resonate with anyone and cannot be found in typical plan documents. But most peple also think that elective deferrals have to be suspended for six months after a hardship distribution.

I agree that if the participant is eligible for a distribution that the entire loan can be distributed at the election of the participant, subject to plan terms concerning distribution.

[Guest wickedp1]

Agreed QDROphile! Have a good rest of the day.