Ability to roll loans from the plan - protected benefit?

We generally write our plans' loan policies to say that in the event of a participant termination, the loan can be rolled out of the plan - this way, if the participant finds a new plan that will take it (which is a big "if" in its own right), they can transfer the loan to the new plan, establish payments, and not have to deal with the extra taxation.  It's a rare moment where I care about the participant. LOL

Thankfully, it doesn't come up very often.  But we just learned that one recordkeeping platform that we work with will not play nicely with this - their policy is to default the loan due to non-payment and then 1099-R it.  They claim it is due to a system limitation.

Obviously, we have to issue new loan policies to all these plans to say that they cannot do this.  So... could this be a protected benefit and therefore not allowed to be cut back?  I figure that since loans themselves are not, then the disposition of them shouldn't be, but I thought I'd see if I was overlooking something.  Thanks.

The participant can still rollover it over to another plan (assuming they can find one that accepts it) and as long as the record keeper properly records the 1099-R Code as a Loan Offset and not a Loan Default as the former is eligible for rollover while the later is not. It just may be an extra step when the individual files their 1040.

This is an interesting conundrum.  There is one element of loan administration that is a protected benefit, but it likely will not help with allowing loan rollovers.

The distribution of an employee's accrued benefit upon default under a loan is a protected benefit under 1.411(d)-4 Q&A 1(c), but nothing else related to loans is protected.

An IRS Issue Snapshot regarding loan offsets notes:

"Plan loan offset

Treas. Reg. Section 1.72(p)-1, Q&A-13(a)(2) provides that a distribution of a plan loan offset amount occurs when, under the plan terms governing a plan loan, a participant's accrued benefit is reduced (offset) in order to repay the loan (including the enforcement of the plan's security interest in the participant's accrued benefit).

A distribution of a plan loan offset amount can occur in a variety of circumstances. For example, a plan loan offset can occur where the terms governing a plan loan require that, in the event of a participant's termination of employment or request for a distribution, the loan be repaid immediately or treated as in default.

Treas. Reg. Section 1.72(p)-1, Q&A-13(b) provides that, in the event of a plan loan offset, the amount of the account balance that is offset against the loan is an actual distribution for purposes of the Internal Revenue Code (IRC), not a deemed distribution under IRC Section 72(p)."

All may not be lost.  The ability to take an in-kiind distribution is a protected benefit under 1.411(d)-4 Q&A 1(b)(2) which says:

"Example 8.

A stock bonus plan permits each participant to receive a single sum distribution of his benefit in cash or in the form of the property in which such participant's benefit was invested prior to the distribution. This plan's single sum distribution option provides two optional forms of benefit."

Technically, the participant who has a loan earmarked to the participant's account is holding that loan as an investment.  If the plan allows for in-kind distributions, then the in-kind distribution of the loan note could be considered a protected benefit.

A final note.  A recordkeeper's system limitation does not take precedence over the plan document, nor does it take precedence over the IRC or agency regulations.  If they wish to cop an attitude, then ask the IRS to ask the recordkeeper about the recordkeeper's system limitations.

I wonder if a loan policy document can create a protected form of distribution benefit. What does the plan document say about distributions? For example, does the plan document provide for in-kind distribution? Does absence of an in-kind distribution provision preclude sneaking in a form of benefit under a loan policy? Does the loan policy controvert, or supplement, the distribution provisions? Similar question with respect to the language in the core plan document regarding loans. Does the core plan document enable or restrict what may be in a loan policy?

By the way, the IRS position on loan rollover is mistaken. A loan cannot be rolled over because under traditional loan rules a loan is extinguished when it is delivered to the borrower. That is what happens when the loan is distributed. But I am not going to argue against a gift from the IRS, and I believe it to be a good policy even if it lacks legal foundation. And maybe the IRS was within its power to make up new law and make exception to the fundamental concepts.

From Paul I: "A final note.  A recordkeeper's system limitation does not take precedence over the plan document, nor does it take precedence over the IRC or agency regulations."

I wonder how many recordkeepers vet the limitations of their "recordkeeping system" against all the plan documents that might be implicated?  I would add: "and against all applicable law and regulations." This sounds like it would be a difficult, time consuming job, yet it is one that should not be avoided. 

On 11/1/2023 at 6:21 PM, QDROphile said:

By the way, the IRS position on loan rollover is mistaken. A loan cannot be rolled over because under traditional loan rules a loan is extinguished when it is delivered to the borrower. That is what happens when the loan is distributed.

QDROphile, I think the way this has to be structured is as a direct transfer. The participant must identify the transferee plan to the transferor plan and then the transferor plan endorses the note to the transferee plan, substituting the transferee plan for itself as the loan's obligee.

Yes, you are correct. But the IRS has issued guidance that allows a rollover of a plan loan, which is usually how it is accomplished since the guidance was issued. Whether or not the rollover is a direct rollover, a rollover is still a distribution. The rules on direct rollovers change the consequences that attend to a regular rollover (before direct rollovers were conceived), and, as announced by the IRS later than other changes, one of those changes is the ability to roll over loans. If the IRS says so, I will not gainsay even if the IRS disregarded general legal principles in the making of the rules. The whole system is artificial. 

38 minutes ago, QDROphile said:

Yes, you are correct. But the IRS has issued guidance that allows a rollover of a plan loan, which is usually how it is accomplished since the guidance was issued. Whether or not the rollover is a direct rollover, a rollover is still a distribution. The rules on direct rollovers change the consequences that attend to a regular rollover (before direct rollovers were conceived), and, as announced by the IRS later than other changes, one of those changes is the ability to roll over loans. If the IRS says so, I will not gainsay even if the IRS disregarded general legal principles in the making of the rules. The whole system is artificial. 

OK, gotcha, QDROphile. I think you're referring to the ability enacted in TCJA 2017 to roll over a loan offset if the offset occurred because you terminated employment and you get the cash together to roll over into an IRA by the due date of your return for the year of offset. Totally a policy decision by Congress to give folks more time to accomplish what they would have been able to do if they had had the cash to pay off the remaining loan balance when they terminated employment.