Participant Loan Default

[austin3515]

Johnny has a $5,000 loan s of 1/12/2017.  He terminates employment as of that date.  His 1099-R is:

a) $5,000

b) $5,000 plus any interest that accrues between 1/12/17 and the end of the "grace period" 

 

I realize that for loans that default when there is no distributable event the interest is accrued through the end of the grace period.  Is the same thing true for terminations (i.e., when there is a distributable event)?

[Lou S.]

I guess the answer depends on when it is defaulted/offset and whether or not the terminated employees has the grace period to repay said loan.

 

 

[austin3515]

option b) includes reference to the grace period.  So assume the grace period ends on 6/30/2017.

[Bird]

I suppose the technical answer is the loan value as of the earlier of 1) the earliest date a distribution could be made, or 2) the date of default.  If distributions are available on the date of termination of employment, I would definitely not accrue through the grace period.  If distributions can't be made 'til...the end of the year, then you're looking at the default date, which is possibly the date of termination, if the loan policy says loans must be repaid immediately upon termination of employment, or the end of the grace period.

But, the practical answer is - most recordkeepers aren't going to credit (charge?) interest unless a payment is made, so it's going to be whatever the value was as of the last payment.  And that is close enough for government work in my book.

[austin3515]

100% agree.  I would definitely not. But a question came up recently and as with many things I am surprised I cn't find a clear answer anywhere.  The regs seem to be pretty clear though that TAXABLE interest accrues through the end of the grace period.  I was just hoping someone could point to something that clarifies one way or the other...

[jpod]

If they were going to repay the loan in full "5 seconds" before the end of the grace period, they would have to repay all accrued interest, wouldn't they?  Wouldn't it be illogical to calculate the deemed distribution any other way? 

[austin3515]

Hjonestly, I would have them pay the amortizartion schedule balance as of the date of term :)  But that's me being a cowboy.

Anyway, if anyone has the "clutch" interpretation of the regs that puts this to bed that would be SWEET!!

[Belgarath]

Try 1.72(p)-1, Q&A-19.

[Tom Poje]

at least 2 websites 'imply' you include the interest

 

http://abaretirement.com/ePAG/aba-0e0-access-funds-web-e.html

Interest and IRS Reporting on Defaulted Loans

Interest continues to accrue on the outstanding amount of a defaulted loan. In addition, if the unpaid amount is not repaid within the applicable grace period allowed by the IRS, the Program will report to the IRS the outstanding amount of the loan and the outstanding interest as a taxable distribution, meaning it is subject to taxes and any applicable IRS penalties. After the loan is reported as a taxable event, it will continue as outstanding debt to the plan and continue to accrue interest. The taxable event does not extinguish the loan.

 

https://www.wellsfargo.com/retirementplansite/worldbank/faq/

What happens if I default on my loan?

When a Plan loan becomes subject to the Plan's loan default process and is eventually declared in default, Internal Revenue Service regulations require that the outstanding principal balance, plus the interest accrued through the date of the default, be treated as having been received as a distribution from the Plan. Therefore, should your loan be defaulted, the deemed distribution of the unpaid amount or the offset of the unpaid amount against your accounts in the Plan will be a taxable event in the year of default and will be reported to the Internal Revenue Service. An IRS Form 1099R or Form 1042 reflecting this loan default (for the year of the default) will be issued to you in the year following the year of the default. This form should be retained with your tax files. In addition, if you are under age 59½, the Internal Revenue Service may impose a 10 percent penalty. At the time you take a final distribution from the Plan, the amount deemed distributed will be offset against your account balance.

[Bird]

Isn't 1.72(p)-1 Q&A 10 crystal clear?  See below; my emphasis in italics - they are definitely adding interest from Nov to Dec in the examples of different default dates.

(I've got myself so twisted around I don't know anymore what we do when a loan isn't on a system...if we even have any.  But I'm not going to try to override what a recordkeeper determines as the default amount.)

(FWIW Q&A 19 is about continuing to accrue interest after a default).

-------------------------------------

A-10: (a) Timing of deemed distribution. Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)(C) and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a cure period and section 72(p)(2)(C) will not be considered to have been violated if the installment payment is made not later than the end of the cure period, which period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.

(b) Amount of deemed distribution. If a loan satisfies Q&A-3 of this section when made, but there is a failure to pay the installment payments required under the terms of the loan (taking into account any cure period allowed under paragraph (a) of this Q&A-10), then the amount of the deemed distribution equals the entire outstanding balance of the loan (including accrued interest) at the time of such failure.

(c) Example. The following example illustrates the rules in paragraphs (a) and (b) of this Q&A-10 and is based upon the assumptions described in the introductory text of this section:

Example.

(i) On August 1, 2002, a participant has a nonforfeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over 5 years in level monthly installments due at the end of each month. After making all monthly payments due through July 31, 2003, the participant fails to make the payment due on August 31, 2003 or any other monthly payments due thereafter. The plan administrator allows a three-month cure period.

(ii) As a result of the failure to satisfy the requirement that the loan be repaid in level installments pursuant to section 72(p)(2)(C), the participant has a deemed distribution on November 30, 2003, which is the last day of the three-month cure period for the August 31, 2003 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 2003. Alternatively, if the plan administrator had allowed a cure period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 2003 equal to $17,282, which is the outstanding balance of the loan at December 31, 2003.

[austin3515]

Timing of deemed distribution

Amount of deemed distribution.

These terms for me raise questions about whether or not it would apply differently in the case where a distributable event exists.  The above terms are for "deemed" distributions, and when there is a distributable event, they are treated as "actual" distributions.  Thoughts?  Your point would need to be that the loan is deemed distributed first, and then offset 2nd.

 

[Belgarath]

Yeah, I was assuming that there was an immediate loan offset as of the termination date. That's the way most plans I see work, as most employers (at least that we work with) don't want anything to do with loan payments from ex-employees. I agree with what you are saying when the plan still allows repayment up to the end of a cure period.

 

P.S. - I was responding to Bird.

[austin3515]

" I agree with what you are saying when the plan still allows repayment up to the end of a cure period. "

Don't they all allow some form of cure period?  I mean I have never seen a loan program say they moment you term, it's all over.  There is always some opportunity to repay