Employee paychecks no longer cover loan payments; what happens on defa

[Guest]

Participant in 401(k) plan (segregated accounts) with 2 outstanding loans comes back to work after maternity leave and now works only 2 days a week (previously full time). Loan payments were payroll deducted prior to leave, but part-time pay is not enough to cover loan payments. Loans were amortized over 5 years originally, so cannot re-amortize to lower payments. If she takes a deemed distribution, is she still required to pay back loans? If so, how? If not, will loans continue to be an investment of the plan and accrue interest?

[QDROphile]

The full answers are in the regulations under section 72(p) of the Internal Revenue Code. The short answer is that after a deemed distribution the loan continues and interest continues to accrue. The loan will not generate any additional taxable income to the participant unless it is repaid, but the loan(s) must be taken into account when you determine eligibility for a future loan. The loan disappears only when offset in a distribution. The participant may repay the loan after a deemed distribution, and the participant will have basis in the particpant's account as a result. Unhappy day for the plan administrator.

Consider whether or not it is possible to repay the loan from sources other than payroll deduction to avoid all this. Consider whether or not you can offset the loan via hardship distribution rather than suffer a deemed distribution.