Voluntary Loan Default in California

Good afternoon,

We have an employee who is looking to voluntarily default on his $50k loan that he initiated in 2018.  He's paid back about $15k but now says the payments are too much and he'd like to stop payments and have the remaining amount defaulted and treated as a deemed distribution.  The employee is still contributing to the 401(k) and receiving match.  He also has about $12k he can take as a distribution.  The participant is 67 years old.  We've talked to our general counsel and they've informed us that we should allow the voluntary default because the employee resides in California.  The IRS doesn't seem to keen on allowing employees the opportunity to circumvent the law.   Has anyone heard of this?

Is the employee eligible for an in-service withdrawal?

If yes - then yes, go ahead and let the participant default. The plan will deem it distributed and offset the remaining balance as an in-service withdrawal. 

Happens all the time. Has nothing to do with being in California. 

In effect he is electing an in-service withdrawal of his loan balance. 

42 minutes ago, Bethany S said:

Good afternoon,

We have an employee who is looking to voluntarily default on his $50k loan that he initiated in 2018.  He's paid back about $15k but now says the payments are too much and he'd like to stop payments and have the remaining amount defaulted and treated as a deemed distribution.  The employee is still contributing to the 401(k) and receiving match.  He also has about $12k he can take as a distribution.  The participant is 67 years old.  We've talked to our general counsel and they've informed us that we should allow the voluntary default because the employee resides in California.  The IRS doesn't seem to keen on allowing employees the opportunity to circumvent the law.   Has anyone heard of this?

I'd be interested in knowing WHY the counsel thinks that California matters in this issue.

On 2/12/2020 at 4:09 PM, justanotheradmin said:

Is the employee eligible for an in-service withdrawal?

If yes - then yes, go ahead and let the participant default. The plan will deem it distributed and offset the remaining balance as an in-service withdrawal. 

Happens all the time. Has nothing to do with being in California. 

In effect he is electing an in-service withdrawal of his loan balance. 

Yes, the employee is eligible for an in-service withdrawal.

On 2/12/2020 at 4:47 PM, Larry Starr said:

I'd be interested in knowing WHY the counsel thinks that California matters in this issue.

Me too - I wonder if it has something to do with garnishment? Maybe employees in California have different rights to reject different types of withholding? But that's just a guess. I don't know much about California. 

On 2/12/2020 at 4:57 PM, Bethany S said:

Yes, the employee is eligible for an in-service withdrawal.

Then yes - by discontinuing the payments he is in effect electing an in-service withdrawal of the outstanding loan balance. In conjunction with a deemed distribution (which is the tax event) this is known as a loan offset. It's also reasonably common. 

What law circumvention are you concerned about? 

On 2/12/2020 at 5:06 PM, justanotheradmin said:

Me too - I wonder if it has something to do with garnishment? Maybe employees in California have different rights to reject different types of withholding? But that's just a guess. I don't know much about California. 

Then yes - by discontinuing the payments he is in effect electing an in-service withdrawal of the outstanding loan balance. In conjunction with a deemed distribution (which is the tax event) this is known as a loan offset. It's also reasonably common. 

What law circumvention are you concerned about? 

Worried about setting some sort of precedence where we establish that people can take a loan and voluntarily default when they get tired of paying.  Our Plan document is silent on this situation since it's a pretty rare occurrence.  

2 minutes ago, Bethany S said:

Worried about setting some sort of precedence where we establish that people can take a loan and voluntarily default when they get tired of paying.  Our Plan document is silent on this situation since it's a pretty rare occurrence.  

This is one of the hazards of having a plan that allows for loans. It happens. Not much the employer can do about it. If the participant is eligible for an in service withdrawal a loan offset occurs in conjunction with the deemed distribution. 

If the participant is not eligible for a withdrawal the loan is deemed distributed - but tracked on the plan's accounting. Fairly standard stuff. 

I suppose you could make loan payments a condition of employment. Tell the employee if they rescind their payment authorization they are fired - but that seems harsh. 

If this participant had more non-loan assets in his account I'm guessing you wouldn't hesitate. He could take an in-service withdrawal - and use the proceeds to pay off the loan balance. He would be taxed on the in-service withdrawal. By discontinuing the payments and defaulting on the loan, the same is occurring, just without the whole tax withholding bit. 

1 minute ago, justanotheradmin said:

I suppose you could make loan payments a condition of employment. Tell the employee if they rescind their payment authorization they are fired - but that seems harsh. 

This would make some attorney out there VERY happy.

4 minutes ago, RatherBeGolfing said:

This would make some attorney out there VERY happy.

yup. I would NOT want to be that employer. 

On 2/12/2020 at 4:47 PM, Larry Starr said:

I'd be interested in knowing WHY the counsel thinks that California matters in this issue.

Here is what outside counsel provided to us.

************************************************************************************************************************************************************************

As I previously noted, payroll practices and procedures are generally considered by the IRS to be matters of state law and deducting from an employee’s paycheck against his or her will in violation of state law is a bigger issue than allowing this loan to default. Accordingly, I took a look at California’s Labor Code, which provides, in pertinent part, as follows:

It shall be unlawful for any employer to collect or receive from an employee any part of wages theretofore paid by said employer to said employee. (Cal. Lab. Code § 221)

The provisions of Sections 221, 222 and 223 shall in no way make it unlawful for an employer to withhold or divert any portion of an employee's wages when the employer is required or empowered so to do by state or federal law or when a deduction is expressly authorized in writing by the employee to cover insurance premiums, hospital or medical dues, or other deductions not amounting to a rebate or deduction from the standard wage arrived at by collective bargaining or pursuant to wage agreement or statute, or when a deduction to cover health and welfare or pension plan contributions is expressly authorized by a collective bargaining or wage agreement. (Cal. Lab. Code § 224)  

Since federal law does not require that employers withhold from participants’ paychecks in order to repay a plan loan, such withholdings seem to be authorized in California as “other deductions” “expressly authorized in writing by the employee.” By requesting that you cease loan repayments from his paychecks, we think that the employee has rescinded his express authorization and that your failure to follow his instructions may violate California law.   

Properly structured, a plan loan can avoid the proscriptions of state wage withholding laws and prevent the employee participant from electing to default.  I am not going to bother with an explanation because neither the IRS nor DOL seem to care about their standards (including prohibited transaction rules) concerning loans or fiduciary compliance with loan origination standards, and plan sponsors and fiduciaries do not want to go to the trouble, and the big automated system providers will never do what it takes.  But don’t say it can’t be done like justanotheradmin did.

56 minutes ago, Bethany S said:

Here is what outside counsel provided to us.

************************************************************************************************************************************************************************

As I previously noted, payroll practices and procedures are generally considered by the IRS to be matters of state law and deducting from an employee’s paycheck against his or her will in violation of state law is a bigger issue than allowing this loan to default. Accordingly, I took a look at California’s Labor Code, which provides, in pertinent part, as follows:

 

It shall be unlawful for any employer to collect or receive from an employee any part of wages theretofore paid by said employer to said employee. (Cal. Lab. Code § 221)

  

The provisions of Sections 221, 222 and 223 shall in no way make it unlawful for an employer to withhold or divert any portion of an employee's wages when the employer is required or empowered so to do by state or federal law or when a deduction is expressly authorized in writing by the employee to cover insurance premiums, hospital or medical dues, or other deductions not amounting to a rebate or deduction from the standard wage arrived at by collective bargaining or pursuant to wage agreement or statute, or when a deduction to cover health and welfare or pension plan contributions is expressly authorized by a collective bargaining or wage agreement. (Cal. Lab. Code § 224)  

 

Since federal law does not require that employers withhold from participants’ paychecks in order to repay a plan loan, such withholdings seem to be authorized in California as “other deductions” “expressly authorized in writing by the employee.” By requesting that you cease loan repayments from his paychecks, we think that the employee has rescinded his express authorization and that your failure to follow his instructions may violate California law.   

 

Hi Bethany,  this is going to be the answer in most if not all states.  Outside counsel pointed to California law because it was a California employee.  We have had this discussion many times on here, and I dont think anyone has ever provided an example of state law that WOULD permit it.

21 hours ago, Bethany S said:

Good afternoon,

We have an employee who is looking to voluntarily default on his $50k loan that he initiated in 2018.  He's paid back about $15k but now says the payments are too much and he'd like to stop payments and have the remaining amount defaulted and treated as a deemed distribution.  The employee is still contributing to the 401(k) and receiving match.  He also has about $12k he can take as a distribution.  The participant is 67 years old.  We've talked to our general counsel and they've informed us that we should allow the voluntary default because the employee resides in California.  The IRS doesn't seem to keen on allowing employees the opportunity to circumvent the law.   Has anyone heard of this?

Bethany, what your real question turns out to be is whether the employer can PREVENT him from stopping his salary repayments of the loan.  And the answer to that is almost always NO.  Almost every state has rules that prevent unauthorized salary deductions from employee paychecks (impermissible garnishment is the phrase generally applied), and employees are actually generally free to stop repayments and then the plan rules regarding default will apply.  All the rest of the "stuff" in your posting appears to be inapplicable to the real issue.  So your client actually has no option to allow or not allow; that is in the control of the participant.

Some might find that a State’s wage-payment law is one that, in this context, “relate to [the ERISA-governed] employee benefit plan[.]”  ERISA § 514(a), 29 U.S.C. § 1144(a).

But even if that’s so and ERISA otherwise would preempt a State’s wage-payment law, ERISA’s preemption “shall not apply to any generally applicable criminal law of a State.”  ERISA § 514(b)(4), 29 U.S.C. § 1144(b)(4).

Many States’ wage-payment laws make a violation a crime.

Would a well-worded promissory note eliminate this issue?

5 hours ago, BenMgr said:

Would a well-worded promissory note eliminate this issue?

Two answers: first one - NO.

Second one: What would be your "well worded" language in the promissory note that would eliminate this issue?

The well-worded language would refer to the attendant wage assignment and security documents., which would have collection operate under the uniform commercial code instead of wage withholding statutes in the event of elective default.  Those of us more affected by sumpsimus than mumpsimus might even argue that securing plan loans by wage assignments is required in an environment of potential elective default under wage withholding laws.  It appears that the IRS and the DOL are not interested, so there is no practical concern.  But there is practical ability to prevent elective default if one wants to go to the trouble.

4 hours ago, QDROphile said:

The well-worded language would refer to the attendant wage assignment and security documents., which would have collection operate under the uniform commercial code instead of wage withholding statutes in the event of elective default.  Those of us more affected by sumpsimus than mumpsimus might even argue that securing plan loans by wage assignments is required in an environment of potential elective default under wage withholding laws.  It appears that the IRS and the DOL are not interested, so there is no practical concern.  But there is practical ability to prevent elective default if one wants to go to the trouble.

I'm far from an expert on this issue and it is also state specific, but....  I wonder if the employe can be held to that UCC reference if, by definition, it is wage withholding.  I would be very cautious about that route and would certainly want council to confirm that actually would prevail. But if it does, it is useful to know.

It is not wage withholding.  It is a creditor remedy more like garnishment.

1 hour ago, QDROphile said:

It is not wage withholding.  It is a creditor remedy more like garnishment.

And it can be revoked, just like withholding.   The available remedy if revoked is wage garnishment through court order. Why would the plan want to go to court to collect on a participant loan?

The proposition is that the employer wishes not to allow participants to be able to choose to default by simply invoking wage deduction law limitations.  Plans are not required to allow loans. Plan loans can have adverse effects on retirement savings, especially premature distribution because of loan default. Most of the responses say that wage withholding laws are fatal to preventing elective default. You may consider the proposition to be overly paternalistic and the efforts not worthwhile and you are on firm ground for that position.  The overwhelming  prevalence of automatic administration products and cost sensitivity makes the the concept of adequate security into a nothing burger, with alternatives seeming bizarre, but it is not true that elective default is unavoidable. 

In states where they are not invalid as a matter of law, you would technically be correct. It would certainly depend on the jurisdiction, but between notice of assignment, revocation of assignment, and seeking a court order for garnishment, I wonder whether there is enough time to cure the default.

My point is I think you would actually expose the plan to more liability with the various state laws governing (and prohibiting) wage assignment.

As Larry Starr advised ... .