Deemed 401k loans - trouble understanding the consequences

Any advice is appreciated.  This may be loan administration 101 but I am not clear on what happens when a participant stops making loan repayments, mostly centered on what happens after a loan is deemed to have been distributed.

Example:

A participant has $100,000 account balance and takes a loan for $20,000.  She repays $5,000 but then stops payments.  The loan goes into default and triggers a deemed distribution.  The participant is still employed.  The outstanding balance (lets say that is $16,000) is taxable in the year of the deemed distribution.  But there is accrued interest of $2,000 remaining on the loan at the time of default.

I keep reading that the deemed distribution amount plus accrued interest must still be accounted for after the deemed distribution.  But when a distributable event does occur, the accrued interest is used to offset the participant's non-loan account balance.  Is that correct?  So if a few years after the deemed distribution, the participant terminates and now has $200,000 non-loan account balance.  She also has an additional $2,000 in accrued interest from the loan.  Is it the case that the participant is paid $198,000?

Thank you for any advice.

16 hours ago, Santo Gold said:

So if a few years after the deemed distribution, the participant terminates and now has $200,000 non-loan account balance.  She also has an additional $2,000 in accrued interest from the loan.  Is it the case that the participant is paid $198,000?

No. Think of the loan as a phantom account. You keep accruing interest on the phantom account, so if, a year after the deemed distribution, she has accrued interest of $2000, her total loan balance is $18,000, which is an effective offset against the $50,000 maximum. That's the purpose of accruing interest. When she takes an actual distribution, she gets her entire non-loan balance, and the loan, whatever the amount at the time, is "distributed" but there is no reporting since it has already been reported (on a 1099-R). 

Anytime we use the word "deemed," we are discussing a legal fiction.  A participant has a loan and they default on the loan, but the loan came out of 401(k) deferrals and the participant is only 40 years old and still employed by the plan sponsor.  The participant is subject to the 401(k) distribution restrictions, so they can't actually have a distribution.  But the IRS wants to collect the taxes due on what was, for all other intents and purposes, a distribution from the plan.  Thus, the participant experiences a deemed distribution which removes the loan from the plan assets and triggers taxation of the balance at the time of default.  But it is not really a distribution, so the loan continues to exist on the plan's books unless and until it is paid off (at which point, the participant would receive basis on the repayment as they have already been taxed).  As Bird notes above, the phantom loan balance can impact future borrowing limits (or even the ability to borrow again, if the plan limits participants to only one outstanding loan at a time), but it also impacts top heavy (as it counts as part of the participant's balance), vested balance calculation, etc.

On 7/27/2023 at 4:19 PM, Santo Gold said:

So if a few years after the deemed distribution, the participant terminates and now has $200,000 non-loan account balance.  She also has an additional $2,000 in accrued interest from the loan.  Is it the case that the participant is paid $198,000?

Keep in mind that in nearly all "modern" 401(k) plans, the participant is paying interest to themself.  In your example, who would get the $2,000 being retained from the participant?  Because the participant is not repaying the loan, the phantom interest accrued equates to a phantom distribution (i.e., there is nothing so they get nothing), but it is not deducted from their other plan assets.

On the topic of deemed loans, we have a participant in a qualified plan that stopped making payments in which after 90 days the loan was deemed and reported on a 1099R.  The active participant would like to borrow again from the plan, the plan allows for one (1) per participant, is the participant permitted to take a brand new loan?  Or will he be required to pay-off the prior deemed loan first before he is able to initiate a new loan?

15 hours ago, 401Karina said:

The active participant would like to borrow again from the plan, the plan allows for one (1) per participant, is the participant permitted to take a brand new loan?

No