Repaying Defaulted Loan

[Stash026]

I know a participant can continue to make repayments on a defaulted loan (if an after-tax account is set up), but are they required to?  I've seen/read different things, so I want to be clear.

Thanks!

[ETA Consulting LLC]

A loan is 'deemed' distributed to become taxable when the loan is defaulted, but it's still a loan.  So, you must allow the participant the opportunity to repay it.  You're not really "setting up an after-tax account", but your tracking the after-tax basis as repayments are made.  The source of funds does not lose it's characteristics (e.g. withdrawal availability).

Good Luck!

[Tom Poje]

in addition, the 'loan' continues to accrue interest so if payments were stopped for a time, then a larger payment is due. If nothing is done, and the participant wants a future loan, this defaulted loan plus interest also counts against the max loan that can be taken.

an eventually when an actual distribution occurs (assuming no loan payments made) this accrued interest is on paper only.

[Stash026]

Great, thanks!  So bascally it has an impact on the amount that can be taken in the future, but it's not mandatory that the person repays the defaulted loan.  Correct?

[401_noob]

Well the ASPPA books say that the obligation to repay is not waived because the loan is deemed distributed. 

Because the deemed distribution treatment under IRC §72(p) is solely a tax rule, and is not treated as an actual distribution for other purposes, the deemed distribution does not affect the  participant's continued obligation to repay the loan. The loan obligation is not extinguished until the loan is repaid, either by the participant through a resumption of loan payments, or by offset against the participant's accrued benefit, pursuant to the plan's security interest. In fact, there is still a fiduciary requirement to enforce the loan, because ERISA requires the governing documents of the plan be followed (e.g., the written loan provisions or loan policy that is part of the plan), and to  protect the benefits of the plan participant.

[JackS]

3 hours ago, Stash026 said:

Great, thanks!  So bascally it has an impact on the amount that can be taken in the future, but it's not mandatory that the person repays the defaulted loan.  Correct?

If this participant is also a Trustee, I would argue, at least to the client, that they are required to repay the loan. 

[Mike Preston]

22 minutes ago, JackS said:

If this participant is also a Trustee, I would argue, at least to the client, that they are required to repay the loan. 

You might, indeed.  But you would lose.

[JackS]

8 minutes ago, Mike Preston said:

You might, indeed.  But you would lose.

A Trustee who refuses to repay his own loan....you are saying there are no possible consequences?  That there is no prudent reason to encourage them to do so?

 

[Luke Bailey]

Re the trustee question, assuming this is a DC plan and the loan is treated as a self-directed investment of the borrower's account, the borrower is not a fiduciary with respect to the loan even if he/she is also a plan trustee. Don't recall whether this is specifically addressed in the 408 or 404(c) regs, but I believe it's in one of them.

To clarify what I think Tom Poje is saying below...

9 hours ago, Tom Poje said:

an eventually when an actual distribution occurs (assuming no loan payments made) this accrued interest is on paper only.

 

...While it is clear under the 72(p) regs that a deemed distribution of the loan does not remove the loan from the account for purposes of the $50,000 loan limit, and so will block any further loans, I think it is also clear that the accrued (let's call it, "phantom") interest is not thereafter includable in the participant's income, either as it accrues or when, generally later, the participant ultimately has a distributable event and the loan is offset. See The first two sentences of Q&A-19 of Treas. reg. 1.72(p)-1.

[Mike Preston]

2 hours ago, JackS said:

A Trustee who refuses to repay his own loan....you are saying there are no possible consequences?  That there is no prudent reason to encourage them to do so?

 

None that I can think of.  You got any?

[RatherBeGolfing]

3 hours ago, JackS said:

A Trustee who refuses to repay his own loan....you are saying there are no possible consequences?  That there is no prudent reason to encourage them to do so?

 

Possible consequence could be losing the ability to take a future loan assuming the defaulted loan doesnt max out the limits.    But other than that, no.

[Mike Preston]

There are certainly differences caused by the investment earnings associated with the repaid amounts (rather than the theoretical phantom interest associated with unrepaid amounts.  Hence, it is possible that a plan that would otherwise be top-heavy (including all the phantom interest) would be not top-heavy (including the less than stellar real rate of return on the repaid amounts).  But to say that might happen once in a blue moon seriously overstates the frequency.

[Larry Starr]

15 hours ago, JackS said:

If this participant is also a Trustee, I would argue, at least to the client, that they are required to repay the loan. 

What?  Huh?  Why would you make such an argument?  It has no basis in fact.

[JackS]

On ‎6‎/‎1‎/‎2018 at 3:54 PM, Mike Preston said:

None that I can think of.  You got any?

 

On ‎6‎/‎2‎/‎2018 at 4:42 AM, Larry Starr said:

What?  Huh?  Why would you make such an argument?  It has no basis in fact.

 

On ‎6‎/‎1‎/‎2018 at 1:23 PM, Mike Preston said:

You might, indeed.  But you would lose.

I don't always lose (or win) this argument but I always present it to my clients.  In short, if you are a Trustee, you have Fiduciary duties.  If you take a loan, you are responsible for paying it back.  Now, you cannot force a participant to pay back a loan but you can force yourself to.  If you are not willing to hold yourself to the fiduciary duties you accepted, this could be a sign of a fiduciary breach.  Would it, in and of itself, cause any problems?  Probably not.  But in an audit where there are other issues, could it be used as additional evidence that you as a Fiduciary are not discharging your duties adequately? I don't know, go ask an attorney or the IRS but I am not going to tell my clients that there are no possible ramifications.     I am going to tell them they should try to figure it out and pay off the loan. 

What if you make your employees sign a payroll deduction agreement but you are taking guaranteed payments so you cannot?  No discrimination here?

Here is a scenario.  Owner of a business takes a loan from his plan on July 1, 2018 and amortizes it quarterly such that a payment is due October 1.  They do not make the October 1 loan payment.  The cure period expires March 31, 2019.   They have to recognize this as taxable distribution in 2019 and pay their taxes by April 15, 2020.  The client just took a distribution from the plan, gave themselves 9 months to make payment and 21 1/2 months before they have to come up with the taxes.  That sure beats taking a $50,000 distribution (if available) and having $10,000 withheld today doesn't it?  Now, assuming they didn't take the loan never intending to pay it back, isn't this accurate?  So if the client needs $ and wants to take it from the plan, isn't it better to do this knowing that they will try to make the payments but if they don't, they just avoided the withholding and deferred the taxation.  No possible ramifications?