Disabled Participant and Loan Offset

[Ananda]

A plan participant under age 59 and 1/2 has recently become permanently and totally disabled. He has 100,000 cash in his 401(k) plan and a 40,000 loan. He wants to withdraw his entire account balance because of dire financial hardship. The plan provides that upon disability the plan participant can withdraw the entire account balance. The plan does not deem that the loan must be paid under these circumstances and the loan is not in default. Here, even though the participant is under 59 and 1/2 there will be no 10% penalty given total and permanent disability.  The participants total account balance should be $140,000, i.e., 100,000 cash and a 40,000 note receivable. However, upon distribution he will only be in receipt of $100,000 cash and not the note receivable. However, if he withdraws the $100,000 cash is this deemed a loan offset of $40,000 ($140,000 account balance less $100,000) that is included in taxable income?  However, my understanding is that a loan offset only occurs if the loan is in default and here it is not. If it's not a loan offset then it's a $100,000 taxable distribution with a $40,000 loan outstanding with the plan. So the participant can ether try to make loan payments or preferably let the loan go into default whereupon its a deemed distribution not subject to the 10% penalty. Another possibility is due to concerns that the IRS may challenge his permanent and total disability diagnosis, he may decide to take a $100,000 hardship withdrawal and let the loan go into default and accept the deemed distribution. Any thoughts on this analysis especially regarding this not being a loan offset?

[Paul I]

You have covered a lot of rules but getting to the answer of each question seems to need some additional information.

First, what are the plan provisions related to disability and disability distributions?  Are they triggered by termination due to disability and/or by being determined disabled by the plan administrator (and the individual is not considered terminated)? 

Why are there concerns that the IRS may challenge his permanent and total disability diagnosis?  If everything is done according to the plan provisions, what basis would the IRS have to make such a challenge?

What does the plan say about the status of outstanding loans in the event of termination from employment?  What does the plan say about the status of outstanding loans in the event of disability?

Keep in mind that a loan offset and a deemed distribution are different things, and a withdrawal and a distribution also are different things each with different consequences.

[Lou S.]

I don't see any reason why a participant qualifying for total and permanent disability would not be an event allowing offset of the loan. The only question would be if this is a permanent and total disability and if the Plan Administrator had made that determination than it is I don't see why his full benefit can't be distributed, assuming the Plan allows for distribution on disability and most DC plans do. I would further posit that the loan offset would likely be a Qualified Plan Loan Offset.