Voluntary Loan Defaults

[Guest ANNEBV]

I have a participant with an outstanding loan who claims that he cannot afford to continue making his loan repayments, so he is considering leaving the company so that he can payoff the loan and receive his vested account balance in the plan (clearly, he has some serious financial problems).

I want to consider the possibility of voluntary loan defaults. I read a previous thread, regarding this topic, but have some questions that I'm hoping someone can answer.

How does a participant officially rescind his/her payroll deduction agreement? Do you need something officially on file to document this? (I would think yes).

Does the loan continue in default (and accrue interest) until the participant has a distributable event under the terms of the plan? Can plan language be added so that the loan can be a deemed distribution in the year of default? (This is a volume submitter plan with a loan provision, not an individually designed plan, if that's germane).

Does any language need to be added to the plan or loan policy to permit voluntary loan defaults or is this simply something that you cannot deny a participant?

Any help would be greatly, greatly appreciated!!

[QDROphile]

The fiduciary of the plan has to enforce the loan, even if the payroll deduction is somehow cancelled. The payroll deduction is simply a convenient collection device. Otherwise, the fiduciary breaches its duty. The plan may also be disqualified because the loan would then be a device to obtain distributions in circumvention of the rules against in-service distributions. The plan can't be drafted to allow "voluntary defaults." If the loan documents don't make it clear that the loan is an enfoceable obliagation, then the loan is bad in the first place. Don't pursue this idea.

The legitimate possibility is to have the loan discharged in bankruptcy. Unfortunately, the law is not clear about what happens to plan loans in a bankruptcy proceeding and there are multiple credible views. One, thing is clear. A bankruptcy stay suspends of collection of loan payments by any means.

[Guest Dianes]

In my experience with plan loans, this is how it works: The participant requesting the loan is required to sign a Promissory Note. This note provides that in the event an individual misses a payment, the loan is in default and the balance of the loan is considered to be a deemed distribution and is treated as such in the year the default occurs. As such, the participant is, of course, required to report the distribution as income for that year and may be subject to the 10% early withdrawal penalty if he/she is not at least 59 1/2. I realize that this would not be a very good option for a participant who is in financial "dire straights". It would get him out of the monthy payments, but would only delay paying Uncle Sam his share.

I agree with QDROphile that payroll deduction is merely one means the participant can make the required payments. Theoretically, the particpant could stop the payroll deductions at any time by contacting the payroll department and begin remitting a check to the plan for the payment amount.

Question - how far does a fiduciary have to go to collect loan payments? In reality, I don't see plan sponsors going to great lengths to ensure that the participant makes a payment.

[MoJo]

Clearly a bankruptcy stays collection on the loan, but does not alter the tax consequences of defaulting on the loan. In some cases, discharge of indebtedness does not create taxable income, but a deemed distribution does. Interestingly, there isn't an answer (that I've found) with respect to the original question posed - although I agree with the prior posts. Automatic deduction is but a convenience for repayment of the loan, and if the participant says "stop," I think state based wage and hour laws would require that you stop the deductions. Some have argued that "ERISA preempts," but I haven't seen any cogent reason why. ERISA requires that the terms of the loan be boba fide, not that the terms of the loan be enforced over other obligations (i.e. what happens if a court orders wage withheld child support payments? Would ERISA say not until after the loan payment is deducted? I think not).

Anyhow - I'd make the participant demand, in writing that deductions stop, then stop payments and run through the delinquent payment process in the loan policy, then default the loan....

[QDROphile]

Depending on state law, if payroll reduction is authorized as a condition of getting the loan, the employee cannot unilaterally cancel the deduction before the loan is paid. A good backup is to get a separate assignment of the pay to secure the loan. Then cancellation of the payroll deduction does not matter; the plan can collect directly under the assignment. Pay assignments should not be done without assistance of counsel. State law must be respected in this area as well.

How much trouble must the fiduciary go to in order to collect on a defaulted loan? It is a matter of judgment and circumstances. But the fiduciary must start from the proposition that the loan should be enforced. It then makes a decision about practicality like any other lender. If the fiduciary decides not to take enforcement action, it should doucment consideration of the issue and the reasons for not proceeding. And if the situation keeps recurring under the plan, the fiduciary needs to consider changing the conditions for loans and the security for the loans. Loans are expected to be repaid. If they are not, it jeopardizes the entire plan.

[RCK]

I guess that I have to be the one to say "what does the plan document say?" Ours say: " All Participants shall make payment of loans by monthly or more frequent payroll deduction. The making of the loan is considered an irrevocable authorization for payroll deduction." And goes on to discuss what to do if the available payroll amount is less than the loan payment.

[MoJo]

I like that approach, RCK, but under state law, can one even make an irrevocable assignment of pay? I'd bet that that is not universally true, (it certainly isn't in Ohio)and the existence of that language in a plan document certainly wouldn't override state law....