Denying a plan loan

[Santo Gold]

A 401k plan allows for plan loans for any reason.  However, a participant who is requesting a loan recently declared bankruptcy, which the company is aware of because they receive a court order to terminate his wage attachment for child support.  Can or should a Plan Administrator deny the request for the loan since they have reason to believe (bankruptcy) that the plan loan would not be paid back?

Thanks

[Lou S.]

The plan can establish procedures to review credit worthiness of plan borrowers. If the plan believes the loan is simply a disguised attempt to circumvent the in-service distribution rules, yes they can reject the loan.

[Santo Gold]

Since the plan only allows for payroll deduction repayments, would credit worthiness, or questioning the ability to repay really play a factor?  Once the loan is established, the participant cannot stop making repayments, since they are coming out of the participant's payroll automatically.  The participant would have to stop drawing  paycheck for the repayments to stop.

[Lou S.]

39 minutes ago, Santo Gold said:

Since the plan only allows for payroll deduction repayments, would credit worthiness, or questioning the ability to repay really play a factor?  Once the loan is established, the participant cannot stop making repayments, since they are coming out of the participant's payroll automatically.  The participant would have to stop drawing  paycheck for the repayments to stop.

I believe in some states a participant is allowed to stop the payroll deductions but I'm not a lawyer so I could be mistaken.

[MoJo]

12 minutes ago, Lou S. said:

I believe in some states a participant is allowed to stop the payroll deductions but I'm not a lawyer so I could be mistaken.

I would agree - and suggest it is in "most" states....

[Peter Gulia]

Santo Gold, I'm curious:  Does the plan's governing document or a written participant-loan procedure say anything about whether the administrator should allow or disallow a participant loan when the participant applies for the loan AFTER filing a bankruptcy petition?

 

[Larry Starr]

7 hours ago, Santo Gold said:

Since the plan only allows for payroll deduction repayments, would credit worthiness, or questioning the ability to repay really play a factor?  Once the loan is established, the participant cannot stop making repayments, since they are coming out of the participant's payroll automatically.  The participant would have to stop drawing  paycheck for the repayments to stop.

1) Credit worthiness is almost irrelevant; I would suggest it DOES NOT play a factor.  

2) The participant CAN stop making repayments in almost every state.  It is the issue of "impermissible garnishment" which every state has severe laws regarding. So even though you can't stop him from stopping payments, now dredging up from my ancient history and research done in the late '70s, I seem to remember that you actually can make it a condition of employment that the loan has to be paid by salary reduction, which means if he revokes permission, he is also quitting his job!

[Santo Gold]

Unfortunately there is nothing in the plan document or loan procedures that address this specific situation.

 

 

[Peter Gulia]

Does the absence of a restriction about bankruptcy suggest the administrator should approve the loan if the administrator would approve it for a similarly situated non-bankrupt participant?

 

[Luke Bailey]

Assuming the loan is allocated to the individual's account as his/her own self-directed investment (100%), then the worst that happens is that the loan defaults and he gets a 1099-R and, if under 59-1/2, has to pay 10% premature distribution tax in addition to regular income tax. The IRS will not be impeded in any collection efforts that it then eventually takes. Not much of an issue for the plan sponsor or administrator. Of course, they could talk to the guy to make sure he understands the consequences.

[Larry Starr]

1 hour ago, Luke Bailey said:

Assuming the loan is allocated to the individual's account as his/her own self-directed investment (100%), then the worst that happens is that the loan defaults and he gets a 1099-R and, if under 59-1/2, has to pay 10% premature distribution tax in addition to regular income tax. The IRS will not be impeded in any collection efforts that it then eventually takes. Not much of an issue for the plan sponsor or administrator. Of course, they could talk to the guy to make sure he understands the consequences.

Luke, why do you think it is any different for a loan that is NOT allocated to an individual account.  I would say the same results as you noted obtain in that situation.

[Luke Bailey]

Larry, (a) there is a theoretical risk of loss to participants other than the borrower where not individually allocated (if value of portion of borrowing participant's account other than portion invested in note declines below outstanding amount of note), and (b) optics. Re (b), if you are making a loan that a reasonable person (e.g. the reasonable folks in the employers HR and payroll dept(s)) would think is very iffy, the optics are better if you know that only the participant is invested in that loan.

[BobbyV]

There is something in the dim recesses of memory that says that bankruptcy law does not allow for additional extensions of credit during bankruptcy without the bankruptcy court's permission.  I believe this applies to all kinds of loans including those from 401(k) plans.  Your client is best off discussing the matter with legal counsel.

[AKconsult]

We use the ASC document and the Loan Policy has language in it that gives the Plan Administrator the discretion to deny a loan if a participant is not credit worthy. But if your document does not have this language, then the loan should probably be approved.  Here is the language from our loan policy:

The Plan Administrator may refuse to make a loan to any Participant who is
determined to be not creditworthy. For this purpose, a Participant is not creditworthy if, based on the facts and
circumstances, it is reasonable to believe that the Participant will not repay the loan.

[Larry Starr]

On 12/9/2019 at 8:06 PM, Luke Bailey said:

Larry, (a) there is a theoretical risk of loss to participants other than the borrower where not individually allocated (if value of portion of borrowing participant's account other than portion invested in note declines below outstanding amount of note),

OK: I just have no idea what you are saying, but I think I disagree! ?

Let me see if I can figure it out.

So, 1) no participant direction of account (it is pooled). 2)  All participant accounts go up and down with investment return of ALL assets. 3) Loan value does not go up and down; it is always the "payoff amount" at any time so long as loan payments are being made. 4)  If ALL the other assets combined lose over 50% of their value (the only way I can see that his account will be worth less than the collateral, which is the note, so what?  The client has a much bigger problem than the fact that the collateral is no longer adequate to secure the debt. The note is still valued at the payoff value even though everything else went down.  His account value is less than the value of the note and if he now defaults by not making payments, he will be taxed on the value of the outstanding loan and his account will go to zero, but the plan still owns the note and it appears that it the only "good" investment the plan has!!!!! 

and (b) optics.

Show me where "optics" is covered anywhere in ERISA.

Re (b), if you are making a loan that a reasonable person (e.g. the reasonable folks in the employers HR and payroll dept(s)) would think is very iffy, the optics are better if you know that only the participant is invested in that loan.

I couldn't care less about OPTICS, and no one else should. It has nothing to do with the running of the plan and the making of loans to participants.

 

[Larry Starr]

6 hours ago, AKconsult said:

We use the ASC document and the Loan Policy has language in it that gives the Plan Administrator the discretion to deny a loan if a participant is not credit worthy. But if your document does not have this language, then the loan should probably be approved.  Here is the language from our loan policy:

The Plan Administrator may refuse to make a loan to any Participant who is
determined to be not creditworthy. For this purpose, a Participant is not creditworthy if, based on the facts and
circumstances, it is reasonable to believe that the Participant will not repay the loan.

I think that language is problematic.  What determines credit-worthy?  If the loan, when made, is 100% collateralized by his account balance, which is twice the size of the loan at the time of the loan, and he is employed and his regular loan payment is less than his regular paycheck, where is the problem?  If he defaults, he DOES REPAY the loan to the plan by the reduction in his account balance.  Therefore, he is credit worthy by the definition of how loans are handled in a qualified plan.  I don't think there is any way (if my conditions above are met) that the participant could be classified as not creditworthy, and if this is applied to a NHCE, I think you have a discrimination issue as well. FWIW.

[Luke Bailey]

Larry, on the loss issue, you may or may not be right, depending on how you handle the default. Assume plan has pooled investments and 2 participants, A and B. Each has 100k account. Plan is invested in mutual funds at time 0, so $200k in mutual funds. At time 1, B takes a loan for $50,000, so immediately after, A and B each have $75k in mutual funds and $25k of B's loan allocated to their accounts. Assume that at time 2, the $150k in mutual funds has not changed value, but B is complete deadbeat and does not repay loan, so 100% loss there. B then terminates employment and requests a distribution. What happens to the $75k of mutual funds in B's account? Do you move $25k of it from B's account to A's to insulate A from the total loss on B's loan?

[Larry Starr]

2 hours ago, Luke Bailey said:

Larry, on the loss issue, you may or may not be right, depending on how you handle the default. Assume plan has pooled investments and 2 participants, A and B. Each has 100k account. Plan is invested in mutual funds at time 0, so $200k in mutual funds. At time 1, B takes a loan for $50,000, so immediately after, A and B each have $75k in mutual funds and $25k of B's loan allocated to their accounts. Assume that at time 2, the $150k in mutual funds has not changed value, but B is complete deadbeat and does not repay loan, so 100% loss there. B then terminates employment and requests a distribution. What happens to the $75k of mutual funds in B's account? Do you move $25k of it from B's account to A's to insulate A from the total loss on B's loan?

Luke, you have a fundamental road block in your mind as to how these work. It DOES NOT work the way you are describing. There is no allocation of $75k in mutual funds and $25k of the loan to "each" of their accounts.  THERE IS NO ALLOCATION OF ASSETS TO ACCOUNTS. They each simply have a $100k account, whether a loan exists or not. Now, we have a default.  We reduce the account of the person who has the loan by the outstanding balance (ignore accumulated interest for this discussion). The assets are still the same ($150k in mutual funds and now a loan that has been closed out/fully recovered by offsetting the participant's account).  We don't have to "move" anything (and we don't).  We just do the math on his account.  A's account isn't affected in any way by the default in your example.  Has the light bulb gone off?

[BenefitJack]

What does the plan document provide?  Most plan documents that provide for loans do not restrict the loan based on creditworthiness of the participant, nor based on the purpose for the loan.  

I don't know of any plan provisions that check creditworthiness by say obtaining a FICO score - such an activity would be required for any participant who requests a loan, resulting in added cost, and a delay.  However, one option a plan sponsor may want to consider is reporting the loan to the credit bureaus - as a means of helping workers establish/improve credit.  

Almost all plans that provide for loans incorporate a minimum loan amount.  Otherwise, plan provisions generally track regulatory/code repayment requirements.  That is, most plan loans are approved regardless of the reason for the loan (good reason, bad reason, no reason whatsoever). 

Based on the above comments, unless the plan is amended to provide for a credit check, the plan provisions may not provide the plan administrator sufficient discretion to reject the loan application.

With respect to stopping payroll deduction repayment, most state payroll statutes and regulations require the worker to authorize every deduction, or, withhold their authorization.  So, the worker can almost always stop deductions (regardless of the reason) at their discretion.  A different result is obtained where a worker makes an annual election (only altered by a change in status, and only where the plan so provides) under a cafeteria plan.  

Personal (and other) loans are permitted after individuals have declared bankruptcy – expect higher interest rates and less access to credit, of course.   

Where loan principal is pooled (say as part of a fixed income investment), all who have assets allocated to that investment may benefit (lose) as a result of the participant loan portfolio.  That is, the interest rate charged for the loan may exceed the return on other fixed income investments, but, the risk of loss is certainly different. 
 

[Luke Bailey]

I think what you're saying, Larry, is that if the plan terminated at the next step in the example, which would force you to stop thinking of it as a "plan" and realize that ultimately this is about assets allocated to accounts belonging to people (we are talking only about DC, i.e., "individual account" plans here, right, not DB? None of what I have been describing applies to DB),  A would suffer half the financial loss attributable to B's having taken the loan. Meanwhile, B did get the cash when he took the loan, so he suffers no real loss at all. In fact, he ultimately gets $125k out, $50k as loan cash, $75k as plan distribution, while A gets only $75k. This is why, IMHO, it is better to individually allocate the loan as an investment SOLELY of the participant who takes it.

[Larry Starr]

36 minutes ago, Luke Bailey said:

I think what you're saying, Larry, is that if the plan terminated at the next step in the example, which would force you to stop thinking of it as a "plan" and realize that ultimately this is about assets allocated to accounts belonging to people (we are talking only about DC, i.e., "individual account" plans here, right, not DB?

Luke, I am probably going to give up after this response, but I'll give it one more college try.

Your sentence above has an "if the plan it terminated..." but you did not complete the sentence; there is no "therfore...", so I have no idea what point you were trying to make.

And no, a termination of the plan would in no way make me stop thinking of it as a plan.

None of what I have been describing applies to DB),  

Agreed, of course.

A would suffer half the financial loss attributable to B's having taken the loan.

NO HE WOULD NOT!  Not ever!!! There is NO LOSS to the plan. The plan is "the bank" and the bank's loan is fully collateralized; do you really not see that? If your bank has a depositor that "defaults" on a passbook savings loan (if you remember what those are), it in NO WAY affects the value of your account at the bank.  It's like you are not trying to understand.

Meanwhile, B did get the cash when he took the loan,

Yeah, that's what a loan is. So what?  What's the point.  He also has a lien against HIS ACCOUNT for the same amount.

so he suffers no real loss at all.

Well, he just got a taxable distribution equal to the loan proceeds, which some would consider a loss, especially if he spend the loan money and now doesn't have the cash to PAY THE TAXES on the distribution.

In fact, he ultimately gets $125k out, $50k as loan cash, $75k as plan distribution, while A gets only $75k.

I AM ASTONISHED THAT YOU SAY THIS!!! Maybe try working it out on paper and see that this statement is just 100% wrong.

Going back to the example, they each had a $100k account.  Our borrower borrowed $50k so his account as a lien against it.  If the plan terminates, the assets are $200k, consisting of $150k in mutual funds and a loan outstanding of $50k.  Each participant gets his account;  the guy who didn't borrow get's $100.  The guy who did borrows gets $100k, consisting of $50k in cash and debt forgiveness of $50k.  NO OTHER PARTICIPANT IS AFFECTED!!!!!!!  Not one dollar!  Not one penny! Why don't you see that?

This is why, IMHO, it is better to individually allocate the loan as an investment SOLELY of the participant who takes it.

Totally off point;  that has NOTHING to do with the issue and is a solution you have devised for a problem that does not exist!!!!!!!

Please tell me the light bulb has gone off; if not, it is not use continuing this discussion because you have a fundamental blockage against understanding what is really going on here; there's no other way I can say it.  I'm not trying to be mean.

 

[Luke Bailey]

Larry, since we seem to have gotten a lot of side issues out of the way, let's just go back to the example, and you tell me where I go wrong. I am going to skip interim gains and/or losses, interest on participant loan, etc. for sake of simplicity.

Assume plan has pooled investments and 2 participants, A and B. Each has 100k account. Plan is invested in mutual funds at time 0, so $200k in mutual funds. Let's assume distributions can only be made in cash. If plan terminated at time 0, plan would sell $200k in mutual funds and distribute $100k cash to A, $100k cash to B. Now, at time 1, B takes a loan for $50,000. Plan sells $50k in mutual funds to raise $50k cash, pays the $50k cash to B. So now plan still has $200k in assets, but they now consist of $150k in mutual funds and a $50k promissory note. A and B each still have an account of $100k. Assume that B terminates without paying any portion of the loan back, and then terminates employment. The plan needs to make distributions on termination. It holds $150k in cash from liquidation of mutual funds and a $50k worthless participant loan note. Does A get $100k in cash and B $50k of cash? That's all I'm asking.

[chc93]

1 hour ago, Luke Bailey said:

Larry, since we seem to have gotten a lot of side issues out of the way, let's just go back to the example, and you tell me where I go wrong. I am going to skip interim gains and/or losses, interest on participant loan, etc. for sake of simplicity.

Assume plan has pooled investments and 2 participants, A and B. Each has 100k account. Plan is invested in mutual funds at time 0, so $200k in mutual funds. Let's assume distributions can only be made in cash. If plan terminated at time 0, plan would sell $200k in mutual funds and distribute $100k cash to A, $100k cash to B. Now, at time 1, B takes a loan for $50,000. Plan sells $50k in mutual funds to raise $50k cash, pays the $50k cash to B. So now plan still has $200k in assets, but they now consist of $150k in mutual funds and a $50k promissory note. A and B each still have an account of $100k. Assume that B terminates without paying any portion of the loan back, and then terminates employment. The plan needs to make distributions on termination. It holds $150k in cash from liquidation of mutual funds and a $50k worthless participant loan note. Does A get $100k in cash and B $50k of cash? That's all I'm asking.

Luke... this is my understanding.  A gets $100K in cash.  B gets $50K in cash, and *already* got $50K as a loan.  The $50K loan may be "worthless" to the plan, but B did get $50K in cash so not "worthless" to B.   And then B gets his $100K account... in one way or another.

[Luke Bailey]

chc93, thanks. I think that is the only right answer. So in effect the loan is allocated as an individually directed investment of the borrower's account in the case of default, but not for "normal" rate of return purposes, i.e., interest. Seems more complicated than just saying that, whether or not the rest of the plan's investments are pooled or individually directed, a participant loan is treated as an individually directed investment of the borrowing participant for all purposes.

[Mike Preston]

6 hours ago, Luke Bailey said:

Seems more complicated than just saying that, whether or not the rest of the plan's investments are pooled or individually directed, a participant loan is treated as an individually directed investment of the borrowing participant for all purposes.

It seems more complicated only because saying it your way is wrong. You can confirm this simply by considering what happens when the first loan payment is made.