Should a plan allow a loan after the participant defaulted on an earlier loan but later fully repaid the loan?

Should a plan allow a loan after the participant defaulted on an earlier loan but later fully repaid the loan?

An individual-account (defined-contribution) retirement plan allows participant loans.

These loans are meant to follow Internal Revenue Code § 72(p) so making a loan is not then treated as a distribution.

The plan has no nonelective or matching contributions, only elective deferrals.

The plan sponsor’s general policy in setting plan provisions is to treat participants as adults who make one’s choices about what to do with one’s money. For example, the plan allows every kind of early-out distribution that can be allowed without tax-disqualifying the plan.

The plan’s current loan policy precludes another loan if the participant defaulted on an earlier loan. That restriction applies even if the participant fully repaid the loan after the default.

The plan sponsor is considering revising the policy to allow a participant to take another loan if the participant has fully repaid the defaulted loan.

Nothing in the plan’s procedure, whether current or proposed, for processing participant loans calls for the plan’s sponsor/administrator to do anything on a particular request. (A loan never requires a spouse’s consent.) Rather, the recordkeeper routinely processes approvals and denials of loans on nondiscretionary terms.

BenefitsLink neighbors, what do you think? Is it a good idea to allow a participant to take another loan if the participant has fully repaid the defaulted loan? Or if it is a bad or troublesome idea, why?

Whether or not it is good or bad to allow another loan to a participant who previously defaulted on a loan but has fully repaid the defaulted loan will be colored by the circumstances.  The fact that a participant's loan goes into default may or may not be an indication that the participant is financially irresponsible or is a poor credit risk. 

We have seen examples where loan repayments are required to be made from payroll deductions and - for reasons beyond the control of the participant (e.g., layoff, LOA, medical leave) - the participant is not receiving a paycheck for several months.  Even if the participant could could afford to make loan repayments by writing checks to the plan, non-payroll-based repayments are not allowed and loan goes into default.

We have seen examples of payroll errors that led to loans going into default for reasons beyond the control of the participant such as:

• The payroll provider changes or the payroll system is upgraded and the loan repayments are not properly set up for a participant.  By the time the issue is fixed, the loan is defaulted.
• Payroll takes loan repayments from the participant's paycheck but does not report the loan repayments on the data feed to the recordkeeper who then defaults the loan.

We have seen examples where the recordkeeper was partly complicit in the default such as:

• The recordkeeper did not recognize loan repayments made by the participant because the participant ID in the recordkeeping system does not match the loan repayments reported on the payroll data file, and the loan is defaulted.
• While not applicable here, the participant had multiple loans and the recordkeeper applied loan repayments in a way that looked as if one loan had an outstanding balance with no repayments being made, and another loan was being paid off prematurely, and the one loan was defaulted.

In the above circumstances it seems that the plan should not have defaulted the loan and the service providers should have worked with the plan to reverse the default, but the service providers flatly refused.  This obviously is a service provider relationship issue, but the participant was still saddled with a defaulted loan.

On the other hand, we have seen examples of participants who go to great lengths to attempt to manipulate a one-loan limit when the participant already has an outstanding loan.  (An old trick was to take an available eligible rollover distribution, payoff the loan, take out a new loan and then rollover the distribution.)

And then there is the financially irresponsible participant who takes out a loan that they cannot repay.

For the plan in question, the fact that the participant repaid the defaulted loan is in part an indication of some level of financial responsibility.  It seems punitive that this participant will never be able to take another loan from the plan for the remainder of their employment with the plan sponsor.

The easy solution would be for the plan sponsor to have the option to review the facts and circumstances for the participant who repaid the defaulted loan and then either approve or disapprove a new loan.  This particular plan sponsor seems reluctant to make any such determination.  A possible compromise may be for the loan policy to allow a new loan after the passage of a fixed time period (e.g. a year or two) following the date of repayment of the defaulted loan.

Paul I, thank you for your helpful thinking.

(If it matters, this plan allows, beyond payroll deduction, other ways to make loan repayments, including one’s individual checks.)

BenefitsLink neighbors, if the participant has fully repaid the defaulted loan, is there any tax-law reason not to allow to allow such a participant to take another loan?

Going back to first principles, the origins of plan loan requirements are based on plan loans that bear no resemblance to today's current proliferation of loans from DC plans, and the idea that the loans should look to what is commercially reasonable (e.g. with respect to interest rates). Leaving my favorite aspect of loan security out of this discussion, the expectation in a commercial loan is that the loan will be repaid. Although most people, including the IRS, treat individual account plan loans as sui generis, examining the myth can be somewhat enlightening. Satisfying the criterion that a loan should not be made unless it is reasonably expected to be repaid has many paths, including having the applicant provide financial information (nobody wants to do that, either on the submission side or the review side) or servicing the loan by payroll deduction (knowing that life and job continuity are uncertain, but it is better than just relying on the good will of the borrower to submit payment and also much easier for loan administration).  A prior loan default does need to be considered in a determination that a new loan is likely to be repaid, and the circumstances of the default and the ultimate payment are relevant (see Peter Julia's comments). The backstops against another default are relevant, which brings the loan procedures under scrutiny and some modification might be the ticket to greater comfort about the expectation of repayment. In any event, I think bringing the plan sponsor into the picture to resolve anything other than to make a plan amendment (which would make the plan sponsor a fiduciary -- another favorite subject of mine that tends to be completely disregarded in the area) is the worst thing that can be done. Somebody is a fiduciary with respect to making loans and that person is the one who should determine availability of a new loan after a default if the loan procedures do not cover the circumstances so well that loan issuance is merely ministerial -- which is what a lot of institutional plan loan procedures think they are so the computers can administer the loan program.

Yes, “the computers can [and do] administer the loan program.”

I don't want to go down the rabbit hole of making decisions based on facts and circumstances. We* set a limit of 2 loans or maybe 1 loan, and then just apply the policy without having to think about it. A defaulted loan is still on the books and counts. if it is repaid, so be it; that frees up availability. The government doesn't care if one or two loans default; 4 or 5 I can see being problematic although the next enforcement of allowing "too many" loans might be the first.

*"We" being the TPA. Our (small) plans look to us for guidance.

Keep in mind that his account is HIS money.  When he borrows from his account he is borrowing his own money and is paying it back to himself with interest.  [Do not tell me how technically the money belongs to the Plan.  The Plan is holding HIS money as a contsructive trustee or as a fiduciary.] 

I don't see why this is even an issue.  If the guy doesn't repay the loan it becomes a distribution at some point with interest.  I don't see how the Plan is in any financial jeapardy.  

Might I also point out is that people generally take out loans because they need the money and they need the money because they are in financial distress and that people who are in financial distress are very likely NOT going to be able to make the repayments in a timely fashion.  

The IRS website points out that: 

"If you don’t repay the loan, including interest, according to the loan’s terms, any unpaid amounts become a plan distribution to you. Your plan may even require you to repay the loan in full if you leave your job.

"Generally, you have to include any previously untaxed amount of the distribution in your gross income in the year in which the distribution occurs. You may also have to pay an additional 10% tax on the amount of the taxable distribution, unless you: (i) are at least age 59 ½, or (ii) qualify for another exception."  

How about implementing a hardship distribution plan or an in-service distribution plan. 

David 

As the background for my query explained: “The plan sponsor’s general policy in setting plan provisions is to treat participants as adults who make one’s choices about what to do with one’s money.”

And “the plan allows every kind of early-out distribution that can be allowed without tax-disqualifying the plan.”