Deemed Distribution - Good test question for the pension geeks!

Participant has 4 loans outstanding; all were taken for 5-year terms.  Vested account balance exceeds $100,000.  Current loan balance, rate and maturity date:  $8500 at 8% matures 4/30/28, $4000 at 8% matures 9/30/28, $4700 at 8% matures 5/15/28 and $20,000 at 6.75% matures 4/30/31.  Loans are consolidated at current rate of 6.75%, new balance of $37,200 with a new maturity date of 6/30/31.  Does this loan consolidation exceed the loan limits and if so, what is the amount of the deemed distribution?

I don't think that it would exceed any limit on the maximum loan amount. However, the replacement loan is not allowed to cause the term of the original loan to extend past 5 years from its original beginning date. Since all of the loans were taken for 5-year terms, the principal on each must be fully repaid by their original maturity dates.

I ran up a quick amortization schedule and it looks to me like 4/30/2028 loan would still be fully repaid on time, but the participant wouldn't have repaid $13,200 (=$8,500+$4,700) by 5/15/2028. The other loans also look similarly problematic.

Please help me learn something about plan design.

Wouldn’t it be simpler to provide that a participant may have only one outstanding loan at a time?

That each next loan must first repay the whole outstanding amount of the preceding loan.

Is there a plan-design reason (beyond inattention) for a plan sponsor not to provide this?

I confess to not having done the arithmetic about participant loan limits.

Am I ignorant about how participants use loans?

Am I ignorant about how recordkeepers account for participant loans?

Yes, if the goal is simplicity, one loan at a time with NO ability to refinance is best.  However, that is not the goal for this client.  Zeller is on the right track.  Hoping someone who is an expert in the loan refinancing rules can determine the amount of the deemed distribution.

Keep in mind that there is no actual "loan" as we understand that term.  A true loan is borrowed money from somebody else, you cousin or a bank. 

The employee is taking a loan from himself/herself, pays it back to himself/herself, and pays the interest to himself/herself (what is the logic of that?).  The only penalty is that the amount of the outstanding loan is not included in the employee's account for purposes of gains, losses and investment experience.  It is more like taking $20 from the cookie jar in the kitchen and paying $21 back a week later. 

Don't lecture me about how the plan defines the "loan" for accounting purposes.  The vested portion is owned by the employee, legally and equitably.  If it's not repaid it becomes a taxable distribution.  At the end of the day the employ receives his/her money and pays the taxes and maybe a penalty.  

In a divorce context we normally include loans  (ignore it) in determining the share to be paid to the alternate payee, unless the loan used for family purposes, in which event we exclude it (net it out). 

Here is a link to TSP loans.  https://www.tsp.gov/tsp-loans/

Here is the IRS link - https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans

NOTE:  THE 5 YEAR PAYBACK LIMIT DOES NOT APPLY IF THE PURPOSE OF THE LOAN TO PURCHASE A PRIMARY RESIDENCE. 

NOTE THAT PETER IS CORRECT IN HIS OBSERVATION THAT A PLAN CAN LIMIT AN EMPLOYEE  TO ONE OR TWO LOANS.  THE PLAN CAN ALSO PROVIDE FOR NO LOANS. 

Brenda Wren, does allowing multiple loans somehow allow a participant to exploit a weakness in Internal Revenue Code § 72(p)’s loan limit?

Or, is using a next loan first to pay off the preceding loan’s outstanding amount, with an amount not so consumed paid to the participant, similar to the effect of multiple loans?

Peter, no, allowing multiple loans does not allow a participant to exploit a weakness in the loan limits.  The loan limit is 50% of your vested balance, not to exceed $50,000, reduced by the highest outstanding balance in the last 12 months.  The latter part of that sentence ensures that the participant pays back the loan and doesn't have a perpetual $50,000 loan outstanding.  And the refinancing rules are there to prohibit exactly what occurred in my example.

We are getting away from my question for the pension geeks!  The refinancing rules are very complicated and normally I can do these calculations when there is just one loan (maybe two) outstanding and it is being refinanced to either reduce the interest rate, extend the maturity or take out additional funds.  Where is Sal Tripodi these days?  Retired!

@Peter Gulia Not sure on the exploitation question, though anything that can be exploited usually will be.  For typical corporate 401ks, we view 2 concurrent loans as a sweet spot (one general-purpose and one residential or simply two total and don't distinguish).  That strikes a reasonable balance between flexibility and complexity. Allowing 4 or 5, by contrast, often creates administrative burdens that outweigh the incremental participant benefit. This leads me to a topic we have been broaching with retirement plan committees.  If a client brought this to us, we would ask: if a participant has reached the point of needing 4 simultaneous loans, should the Plan administrator/committee ask whether the plan is functioning more like a revolving credit facility than a retirement savings vehicle.  Given your fiduciary background we thought you might be interested.... we have started recommending to the retirement committees we work with to periodically evaluate their loan policy as part of their fiduciary oversight.  Even though the decision to offer loans (or how many loans to permit) is generally a settlor function, the committee can monitor operational experience. Metrics such as default rates, average number of loans per borrower, deemed distributions, refinancing frequency, and correction activity can help identify whether the program is operating as intended. Those data points can then be shared with the plan sponsor if the sponsor is considering changes to the loan policy.  Not many committees do this, but it seems to us to possibly be a best governance practice as plan administration and fiduciary oversight continue to evolve.  ERISA does not require plans to offer participant loans, offering loans is a settlor function, however, once offered....  (We note that the litigation risk here is not the same as say as the risk from class action investment litigation but likely more indirect from failures that may occur under the plan.)   We believe that there can be many disadvantages of having a multiple loan program than many sponsors/committees appreciate.    

@Brenda WrenAs to your original question:  Applying the Treas. Reg. math to your facts--Highest balance during last year $37,200, Current balance $37,200, statutory limit $50,000.  Applying Q&A-20 the outstanding old loans $37,200 + the replacement loan $37,200 = amount tested $74,400 with limit of $50,000 so it seems the potential excess is $24,400.  Under a "mechanical" reading of the regulation that seems to me to be the deemed distribution—not because the participant received $24,400 in cash, but because the replacement loan causes the tested amount to exceed the statutory limit.

With that said, wondering what folks might think about an "alternative" line of thought using a "technical" reading of the Regs that once utilized because an independent RK was amenable (and able) to "consolidate" a set of similar loans (3 in that case) and separately amortize each loan within the "consolidated" loan.  Under this alternative, using your fact, the original loans A, B, C, D, under the Regs, cannot become payable in 2031.  However, the Regs also seem to state this cannot be done unless the replacement note can be viewed as containing multiple internal amortization schedules.   Last sentence of Q20 of 1.72p states (also look at Examples):

This paragraph (a)(2) does not apply to a replacement loan if the terms of the replacement loan would satisfy section 72(p)(2) and this section determined as if the replacement loan consisted of two separate loans, the replaced loan (amortized in substantially level payments over a period ending not later than the last day of the latest permissible term of the replaced loan) and, to the extent the amount of the replacement loan exceeds the amount of the replaced loan, a new loan that is also amortized in substantially level payments over a period ending not later than the last day of the latest permissible term of the replacement loan.

Using your facts and a literal reading of the Regs:  suppose the new note is drafted where outstanding principal: $37,200, with Component A $8,500, repayment schedule ends 4/30/28; B $4,000 ends 9/30/28; C $4,700 ends 5/15/28/; and D $20,000 ends 4/30/31.  This would be structured under one promissory note and payroll would do one deduction (nothing in the regs would require 4 different ACH drafts).  Operationally then it would be one loan but analytically Treas Regs seem like it would treat it as 4 loans.  Does this fit within that quoted language above?  Most recordkeepers won't structure it in this manner because administratively difficult.... they want the old loans to disappear, just one new loan, 5 years to start over, simple programming, and, granted, still potential tax risk.  This was a technical legal application with no specific IRS authority.  In our case, 2 loans were originally for 3 year terms and extended to 5 year terms (which is permitted under the last clause of the sentence quoted above)  and one loan stayed within its original 5-year term with all having lower interest rates.  Essentially, in our case, the payroll deductions were applied to loan A first, loan B second, and loan C last so they could be paid in the time frame required. 

Of course, this is not a recommendation or advice as I know of no specific authority that permits it.  Just looking back and wondering if anyone else thinks this works (or could work) or is it an overly technical reading?

@fmsincI don;t think it is the case but the size of your font as well as the bolded all caps at the end of your post makes it seem like you are upset with someone... maybe it was just a cut and paste.  

Thank you, Artie.  The answer is calculated more easily than I thought!  The harder question is how to avoid a deemed distribution when consolidating the loans.  What is the latest maturity date you could apply to the consolidated loan (assuming recordkeeper can only accommodate one loan, with one maturity date and one interest rate)?  April 30, 2028 would surely do it, but is there a later date than would work also?