Plan Issues Loan to Participant Who Terminated Employment

[rocknrolls2]

Employer X maintains a 401(k) plan for its employees. On October 22, Employee G terminated his/her employment with X and started working for Employer Y. On October 23, G requested a loan on his/her 401(k) account balance under the Employer X 401(k) plan. Since G was no longer an employee of X at the time s/he requested it, there is an operational violation under the X 401(k) plan. What can X do to correct this error? For example, should it pay off the loan with its own funds and enter into a loan arrangement with G so that G repays X for the amount of the erroneously granted loan (but this gives G a windfall by restoring his/her pre-loan account balance)? Should X immediately subject G to tax on the amount of the loan and inform G that the amount cannot be rolled over? Would it make a difference if G is a highly compensated employee?

[Lou S.]

How are loans of terminated participants dealt with normally?

Does the loan become due in full or taxable income? If so I would treat it that way.

I would not pay it off with funds from the employer as this would seem to compound the error being a potentially prohibited transaction.

[QDROphile]

Nothing legally wrong with the employer loaning the funds to the former participant for payment of the plan loan to avoid the adverse consequences of alternatives. It is not a good idea in general to have employees or former employees as debtors.