Loans and withdrawals

[Cynchbeast]

We ran into an interesting situation. We have 401(k) where owners already took out loans, have fully vested Profit Sharing money and plan allows for in-service after age 50. Both owners (h/w) have taken distributions from their PS such that now both account balances are well below the loan amounts. Husband is still employed but over 50, and so is taking in-service. Wife terminated a few years ago but wants to leave what is left of her money in the plan.

Since the 50% limitation for loans is designed to provide a remaining account balance sufficient to secure the loan, what about this situation. We are aware of no restrictions that keep the participants from withdrawing after they have taken their loans. In fact, since the loan balances are now more than the remaining invested balances, the wife would actually end up owing money were she to take a total distribution.

Thoughts and experience on this issue?

[Lou S.]

The restriction is only at the time the loan is taken. After that all bet are off.

Why would the wife owe money? Would she just receive a loan offest as part of her distribution should she take a full distribution?

[My 2 cents]

The restriction is only at the time the loan is taken. After that all bet are off.

Why would the wife owe money? Would she just receive a loan offest as part of her distribution should she take a full distribution?

Not involved with 401(k) loans, but here are my opinions (for what they are worth), even presuming that the 50% of balance restriction only applies when the loan is issued:

If I correctly understand the original post, the history might look like this:

Husband (owner): Had an account balance of $200,000, borrowed $50,000, has paid the loan down to $40,000. Has taken withdrawals of $170,000, so account balance is now only $30,000. Loan offset of full account balance would leave $10,000 unrepaid.

Wife (ditto): Same numbers. ["...should she receive a full distribution" - hasn't she already received in cash more than 100% of her account balance?]

No matter what, the owners should be compelled (through legal action, if necessary) to pay the remainder of the loan amounts back to the plan. Forgiveness of that indebtedness should not be an option. If it were an option, however, wouldn't the entire amount forgiven be treated as a taxable distribution (i.e., pay nothing more, receive nothing more, but the $10,000 still owed is forgiven, ergo $10,000 treated as a taxable distribution)?

How or why would they have been allowed to withdraw amounts large enough to leave an account balance insufficient to cover the rest of loan?

Would any of this have been considered a fiduciary violation? A prohibited transaction? It doesn't sound right to me.

[ESOP Guy]

How do you take an in-service so your balance is less then the loan?

That sounds like an administrative error that needs to be corrected-- ie the plan administrator over paid these people.

I guess I am saying I agree with 2 cent.

[rcline46]

Major misunderstanding of how a loan works in a non-insurance plan. A loan is treated as a directed investment. Cash is removed from the plan, and an asset called a loan is created. In 2cents example, the balance after the loan is $150,000 in cash and $50,000 in a loan (a receivable). He could not then take an inservice of $170,000, only $150,000 (which is legal). If he had paid back $10,000 then he could take an inservice of an additional $10,000 (interest payments are ignored).

Nothing is out of line here.

It is different for many plans handled by insurance companies - think older 403(b) plans. Here the insurance company actually loans the money, and you pay back the insurance company (and they keep the interest). The Ins. company places al lien against your balance, but you keep all of your money invested. They will not let any funds be disbursed that would reduce the invested balance below the lien amount.

[ESOP Guy]

Another issue that comes to mind is this:

Since these two took too much cash out of the plan does someone owe the remaining participants lost earnings because there is less cash in the plan that is invested? It would seem like the answer is "yes". You should compute the difference between what the investments made and the interest paid (assuming the interest goes into general earnings and not just back to the people paying it-- ie this is a balance forward plan that treats loans as a general investment). Given how the market has done in the past few years my guess is the investments made a better return then the loans did.

I stand by my statement you have an administrative error hear that needs to be corrected.

If anyone doubts me on that then ask yourself this questions: If the husband and wife don't pay back the loan how do the rest of the people get their full account balances? Based on the OP there isn't enough cash in the plan to pay everyone what is showing on their participant statements.

[Lou S.]

The restriction is only at the time the loan is taken. After that all bet are off.

Why would the wife owe money? Would she just receive a loan offest as part of her distribution should she take a full distribution?

Not involved with 401(k) loans, but here are my opinions (for what they are worth), even presuming that the 50% of balance restriction only applies when the loan is issued:

If I correctly understand the original post, the history might look like this:

Husband (owner): Had an account balance of $200,000, borrowed $50,000, has paid the loan down to $40,000. Has taken withdrawals of $170,000, so account balance is now only $30,000. Loan offset of full account balance would leave $10,000 unrepaid.

Wife (ditto): Same numbers. ["...should she receive a full distribution" - hasn't she already received in cash more than 100% of her account balance?]

No matter what, the owners should be compelled (through legal action, if necessary) to pay the remainder of the loan amounts back to the plan. Forgiveness of that indebtedness should not be an option. If it were an option, however, wouldn't the entire amount forgiven be treated as a taxable distribution (i.e., pay nothing more, receive nothing more, but the $10,000 still owed is forgiven, ergo $10,000 treated as a taxable distribution)?

How or why would they have been allowed to withdraw amounts large enough to leave an account balance insufficient to cover the rest of loan?

Would any of this have been considered a fiduciary violation? A prohibited transaction? It doesn't sound right to me.

If it is a pooled account and that is what happened then someone screwed up in allowing the in service distribution. Yes it could very likely be both a fiduciary breach (if husband and/or wife are fiduciaries) as well as a potential prohibited transaction since the plan has esenitally loaned unsecured monies directly to them.

I guess we just work mostly with participant directed plans where this really is never an issue.

[rcline46]

Cynchbeast - is this and individually directed account, pooled account, self directed brokerage account? It seems we are making assumptions that may not apply to this plan. Are there other participants?

[Cynchbeast]

Individually directed with American Funds. In round figures:

• Husband (still employed) had $43,000 balance, took $20,000 loan then $10,000 in-service; remaining invested balance is $13,000
• Wife (terminated) had $42,000 balance, took $15,000 loan then $16,000 distribution; remaining invested balance is $11,000

In both cases, they now have remaining balances less than outstanding loans due strictly to distributions, not market fluctuation.

[masteff]

Then your answer is the first one above: the 50% restriction is at the time of the loan.

The plan technically has a note which is an asset equal to the outstanding balance of the loan. If either made a full distribution today, you would distribute 1) their current investment balance and 2) a taxable event for the unpaid balance of the loan.

[My 2 cents]

I still think that the participants should have to pay back the outstanding balance of the loan, else the plan administrator must go after them for repayment. Especially if there are other participants! The plan adminstrator's duty is not to the owners but to the plan participants (and to see to it that the plan provisions are properly carried out). If the distributions were bigger than they should have been (based on the plan provisions), the plan administrator must actively seek restitution to the plan from the recipients of the overpayments.

Having terminated, how is the wife-owner repaying the loan?

[ESOP Guy]

Now with more details I agree with masteff and retract the idea there has been an error.

I would also say that the OP doesn't describe it correctly. The outstanding loan balance isn't larger then their account balance.

For example in this case the husband's loan balance is: $33,000 which is made up of $13k in investments and $20k in loan.

That seems to be part of the issue here. The loan is part of their account balance so their loan can't be larger then their account balance. At most it can be 100% of their account balance if they took 100% of their cash as an in-service. In this case the other participants aren't at risk of not being paid.