Participant Loan

Participant comes into plan sponsor and says I am NOT repaying this loan any longer.

What is a plan sponsor/trustee to do?  That's it.  That's the question.  I'll be darned if this question has ever been answered.

Default the loan under the plan's loan provisions.

Issue 1099-R for the income.

Carry the loan including accrued interest on the books against the participants loan limit until the participant has a distributable event.

Depends on how the payment provisions are set up.  If the participant is still an employee and has merely a consent to withhold from pay to secure the loan (shame on the fiduciary), then there is an argument that the employee may cancel the consent.  No comment at this time on the argument.  The recipient of the statement has some choices to make about the response.  If the recipient believes that the consent may be withdrawn and wishes to assist, the the recipient advises the employee and informs about the consequences of default. If the recipient does not wish to assist, then the recipient (1) refers the employee to the appropriate plan representative, or (2) has to come up with an evasive answer, such as, too bad.  Or refer the participant to the SPD or whatever document explains the loan policy, including explanation of procedures (including withdrawal if consent?) and consequences of default.

Because the naked payroll deduction represents most arrangements, I am not going to bother with other scenarios unless you ask.

What is a naked payroll deduction?  Something that is not irrevocable basically?

No.  It is simply a consent to have loan payments deducted from pay, without more to secure the loan.  The general view is that state law allows the consents to be revoked. That is another question that has been addressed repeatedly in this forum.

Thats what I've always though, but I have a lot of clients who are very afraid of doing that because if word gets out that repaying loans is "voluntary" then it might become a pretty popular option (tax consequences notwithstanding).

Then a better security arrangement should be implemented.

Or if employees abuse it, amend out plan loans. They aren't a protected benefit.

BTW, your clients will not like better security arrangements, because they are not available off the shelf from the providers.  They are not available from providers because they cannot administered with a push of a button, and the general market will not tolerate cost of administrative arrangements that cannot be mechanized. 

16 hours ago, austin3515 said:

I'll be darned if this question has ever been answered.

It's sure been debated here, ad nauseum.  IMO if a participant says to an employer "stop withholding my loan payments" then the employer does it, and the loan eventually defaults.  QDROphile alludes to the counter argument that the election to have payments withheld is irrevocable, and depending on state law, cannot be changed.  I've never learned which states would effectively force a participant to continue withholding on something they no longer wanted.

The typical 401(k) participant loan agreement -- https://www.shrm.org/resourcesandtools/tools-and-samples/hr-forms/pages/401k_loanapplication.aspx -- includes a consent to repay the loan through payroll deductions.  It is a contract so one party can't unilaterally change its terms.  The participant agreed to it.  State law is pre-empted by ERISA.

So in response to the question posed by the original post, the plan sponsor should do nothing but explain to the participant that loan repayments will continue to be deducted from the participant's paychecks.

I believe this is correct, but am not 100% confident in my conclusion.  I don't believe the IRS or DOL has addressed the issue.

14 minutes ago, MWeddell said:

State law is pre-empted by ERISA.

So in response to the question posed by the original post, the plan sponsor should do nothing but explain to the participant that loan repayments will continue to be deducted from the participant's paychecks.

I believe this is correct, but am not 100% confident in my conclusion.  I don't believe the IRS or DOL has addressed the issue.

 

I disagree that state wage and hour laws are pre-empted by ERISA.  ERISA's pre-emption only applies where state law is inconsistent with ERISA.  I defy anyone to find ANYTHING in ERISA that says one can mandate a particular form of payment, and as you say, the "consent" is a "contract" and contracts are governed under state law, and many state laws provide that employees cannot be forced to have amounts withheld from pay absent (on-going) consent.

Show me the inconsistency between state law and ERISA here.  It simply doesn't exist.

Adding to @Bird comment, we sure have had long and sometimes heated discussions about this.  In my opinion, an employer that refuses to stop withholding loan payments at participant's request better have general counsel on speed dial.  As @QDROphile points out, there are ways to get around that, but it is complicated and expensive, which is why employers wont do it for what is supposed to be a fairly simple add on.

I don't think state law would prohibit the request to stop withholding.  Basically, if a participant can stop having payroll deductions taken out, the plan loan program does not satisfy the requirements and the plan has operational and document issues.

Edit:  Last paragraph is the counter argument I usually hear, not my opinion.

Just now, RatherBeGolfing said:

... there are ways to get around that, but it is complicated and expensive, which is why employers wont do it for what is supposed to be a fairly simple add on.

 

Speaking from a service provider's perspective (bundled recordkeeper) - it would *never* be implemented unless the employer themselves implements something - and even that would bungle up things.  Even something like filing a "mortgage" for a loan for the purchase of a principle resident is impossible and cost prohibited to do (and would require compliance with 50 different state requirements, and probably even more local protocols to perfect an interest).

Loans are evil.  'nuff said.

15 minutes ago, MWeddell said:

State law is pre-empted by ERISA.

@MoJo beat me to it,  preemption just doesn't apply here.

4 minutes ago, RatherBeGolfing said:

I don't think state law would prohibit the request to stop withholding.  Basically, if a participant can stop having payroll deductions taken out, the plan loan program does not satisfy the requirements and the plan has operational and document issues.

Maybe I am just being dense here, but these two sentences seem contradictory?  The first seems to say participants can request a cessation of withholding; the latter says if permitted the plan is disqualified?

I cannot believe this has still not been resolved. So frustrating!

1 minute ago, austin3515 said:

Maybe I am just being dense here, but these two sentences seem contradictory?  The first seems to say participants can request a cessation of withholding; the latter says if permitted the plan is disqualified?

I cannot believe this has still not been resolved. So frustrating!

I don't agree that the plan has a problem.  The plan has to offer loans consistent with the regs (non-discriminatory, compliant with 72(p), etc.) and be on "commercially reasonable" terms.  ALL of those criteria apply at the time the loan is intiated/taken.  Subsequent events have no bearing on the plan's compliance with it's loan policy and the regs.  There may be a "fiduciary" issue in not attempting to collect a loan - but that is more of an academic conversation unrelated to plan "qualification" issues.

Loans are (still) evil.

3 minutes ago, austin3515 said:

Maybe I am just being dense here, but these two sentences seem contradictory?  The first seems to say participants can request a cessation of withholding; the latter says if permitted the plan is disqualified?

I cannot believe this has still not been resolved. So frustrating!

Well I was addressing Bird's comment on the counter argument, and I don't agree with the argument. The laws don't conflict because ERISA does not require payments by payroll deductions, just regular payments.  On the other hand, many (most?) states do have laws against payroll deduction after the participant withdraws consent. the laws are different, not inconsistent. 

We are better off just not doing loans  No frustration

Interesting discussion.  I've looked into it more, spurred on by MoJo's forceful challenge, and now it is as clear as mud to me!

The DOL has ruled on this issue before.  ERISA Opinion Letter 96-01A concerns whether a Puerto Rican law is pre-empted by ERISA "insofar as it may be applied to prohibit a pension plan from requiring the repayment of plan loans through payroll deductions."  The DOL writes:  "Although the Department's previous opinions did not address the specific issue presented here, which concerns the discretionary methods by which a plan chooses to operate a participant loan program, we reach the same conclusion."  The DOL concludes:  "Therefore, it is the position of the Department that, to the extent P.R. Act 17 is interpreted to prohibit the repayment of plan loans through payroll deductions to employee benefit [*7] plans covered by Title I of ERISA, it is preempted by section 514(a) of ERISA."  While there have been subsequent DOL rulings addressing that ERISA pre-empts state withholding laws regarding plan contributions, most recently a 2018 DOL Information Letter, none of the subsequent rulings address plan loans. 

It is possible to distinguish ERISA Opinion Letter 96-01A as applicable to the specific Puerto Rican law in question, which expressly affects pension plans, not perhaps not might not pre-empt other states' wage withholding laws.  Note, however, that that argument depends on the wording of the specific state statute, not on the difference between contributions and loan repayments.

The issue has been discussed at least a half dozen times in threads on these message boards.  Of the threads I reread, the best prior discussion is from 2001.  It addresses ERISA Opinion Letter 96-01A and MoJo also participated in that discussion, arguing his view even more persuasively: 

I still lean in favor of not honoring the participant's request to revoke the payroll withholding based on DOL Opinion Letter 96-01A but the issue is certainly muddy enough that I would refer the client to consult with its legal counsel.

As Rather be Golfing points out,  a (the?) solution is not through reliance on the state laws that deal with consent to payroll deduction and the interpretation and pre-emption arguments, although payroll deduction is a starting-point feature for loan administration works just fine until termination of employment or participant challenge to payment.  The payroll deduction should be coupled with an assignment of pay, which is a creditor tool under state Uniform Commercial Codes, which can vary in application and requirements.  And Rather Be Golfing is correct about the practical disadvantages.

The next time anyone sees or hears of a problem related to a default that happened because a participant told the employer to stop WH, please let us all know, and I can add it to my worry list.

Having said that, I could see a situation where there is a pattern of loans being taken out and not repaid that would rightly be seen as non-compliant.  But the occasional stoppage of WH...no.

3 hours ago, MWeddell said:

Interesting discussion.  I've looked into it more, spurred on by MoJo's forceful challenge, and now it is as clear as mud to me!

The DOL has ruled on this issue before.  ERISA Opinion Letter 96-01A concerns whether a Puerto Rican law is pre-empted by ERISA "insofar as it may be applied to prohibit a pension plan from requiring the repayment of plan loans through payroll deductions."  The DOL writes:  "Although the Department's previous opinions did not address the specific issue presented here, which concerns the discretionary methods by which a plan chooses to operate a participant loan program, we reach the same conclusion."  The DOL concludes:  "Therefore, it is the position of the Department that, to the extent P.R. Act 17 is interpreted to prohibit the repayment of plan loans through payroll deductions to employee benefit [*7] plans covered by Title I of ERISA, it is preempted by section 514(a) of ERISA."  While there have been subsequent DOL rulings addressing that ERISA pre-empts state withholding laws regarding plan contributions, most recently a 2018 DOL Information Letter, none of the subsequent rulings address plan loans. 

It is possible to distinguish ERISA Opinion Letter 96-01A as applicable to the specific Puerto Rican law in question, which expressly affects pension plans, not perhaps not might not pre-empt other states' wage withholding laws.  Note, however, that that argument depends on the wording of the specific state statute, not on the difference between contributions and loan repayments.

The issue has been discussed at least a half dozen times in threads on these message boards.  Of the threads I reread, the best prior discussion is from 2001.  It addresses ERISA Opinion Letter 96-01A and MoJo also participated in that discussion, arguing his view even more persuasively: 

I still lean in favor of not honoring the participant's request to revoke the payroll withholding based on DOL Opinion Letter 96-01A but the issue is certainly muddy enough that I would refer the client to consult with its legal counsel.

3 hours ago, MWeddell said:

Interesting discussion.  I've looked into it more, spurred on by MoJo's forceful challenge, and now it is as clear as mud to me!

The DOL has ruled on this issue before.  ERISA Opinion Letter 96-01A concerns whether a Puerto Rican law is pre-empted by ERISA "insofar as it may be applied to prohibit a pension plan from requiring the repayment of plan loans through payroll deductions."  The DOL writes:  "Although the Department's previous opinions did not address the specific issue presented here, which concerns the discretionary methods by which a plan chooses to operate a participant loan program, we reach the same conclusion."  The DOL concludes:  "Therefore, it is the position of the Department that, to the extent P.R. Act 17 is interpreted to prohibit the repayment of plan loans through payroll deductions to employee benefit [*7] plans covered by Title I of ERISA, it is preempted by section 514(a) of ERISA."  While there have been subsequent DOL rulings addressing that ERISA pre-empts state withholding laws regarding plan contributions, most recently a 2018 DOL Information Letter, none of the subsequent rulings address plan loans. 

It is possible to distinguish ERISA Opinion Letter 96-01A as applicable to the specific Puerto Rican law in question, which expressly affects pension plans, not perhaps not might not pre-empt other states' wage withholding laws.  Note, however, that that argument depends on the wording of the specific state statute, not on the difference between contributions and loan repayments.

The issue has been discussed at least a half dozen times in threads on these message boards.  Of the threads I reread, the best prior discussion is from 2001.  It addresses ERISA Opinion Letter 96-01A and MoJo also participated in that discussion, arguing his view even more persuasively: 

I still lean in favor of not honoring the participant's request to revoke the payroll withholding based on DOL Opinion Letter 96-01A but the issue is certainly muddy enough that I would refer the client to consult with its legal counsel.

What you describe is a ruling that indicates that a condition to initiate a loan - being a requirement that payroll deduct be the only way to repay the loan, cannot be prohibited by a non-federal law.  IT DOES NOT say that state based wage and hour laws can't give a participant the right to then remove consent to continuing withholding from their paycheck.  There is a difference....

I found this discussion and the authorities referenced very helpful, but I want to make sure I understand one point correctly. If, either because your loan documents are written in such a way that they don't appear to attempt to overcome state wage withholding law, or because you take the position that ERISA does not preempt those laws, your conclusion is that the employee can revoke his or her withholding consent, why is that a big deal? You just deem the loan and move on, right? Then offset whenever he or she terms.

Here is a link to a discussion that I started a couple of years ago:  

The discussion moved into the question that was asked in this post, about revoking payment through salary deduction.

My last question was, and I don't recall if it was ever answered, how do these rules work with the plan's inservice distribution rules?  

Is the ability to revoke your salary deducted loan payments and default on a loan a way to get around the plan's inservice distribution rules?

The issue which is a very real one in my opinion is that participants talk to each other and it becomes known that you can just do this.  Take a well meaning HR manager who knows it is an option.  A participant comes in and says "I can't pay my bills".  The well meaning HR says "hey let's stop paying your loan".  Now 3 people have done it. They tell their friends.  I'm just saying its possible that the loan program could get into trouble pretty quickly.  Lower paid employees want the money and they don't want to repay the loans.  Many would jump at the opportunity to stop the payments.  Maybe not immediately but at some point over the 5 year period, "probably" they will.

Maybe I'm being to cautious but I will say many clients have made this issue first.  In fact if I'm not mistaken it may be a client who first made this point me umpteen years ago.

If the sponsor is worried about wide spread participant loan fraud, don't offer loans.

Austin, I believe you. I had two different clients that adopted QDRO policies to disallow distributions to alternate payee until the participant was eligible. They had unusual experiences with sham divorces (the word got out) and their remedy was to lock up all alternate payees to take the temptation away. I am also aware of the phenomenon of credit junkies and plans that allow multiple loans. The money was borrowed as fast as repayments met the standard for borrowing again.

15 hours ago, Luke Bailey said:

I found this discussion and the authorities referenced very helpful, but I want to make sure I understand one point correctly. If, either because your loan documents are written in such a way that they don't appear to attempt to overcome state wage withholding law, or because you take the position that ERISA does not preempt those laws, your conclusion is that the employee can revoke his or her withholding consent, why is that a big deal? You just deem the loan and move on, right? Then offset whenever he or she terms.

Luke, the main question is whether an employee can revoke consent to withhold loan payments. 

One side says yes, because even though a participant may have pledged to pay back via payroll withholding, not honoring such a request is likely to run afoul of state wage withholding laws.

The other side says no, because the participant made an irrevocable pledge to withhold loan payments, and if there are state laws regarding wage withholding they are preempted by ERISA.  Some also argue that if withholding can be revoked, the pledge was not irrevocable, and the loan did not meet the requirements for a participant loan.

The counter to preemption is that since there is no ERISA requirement that repayment is made via payroll deduction, there is not conflict with state wage withholding laws.

As for why it is a big deal, some would argue that if a participant with a loan has the ability to create a default/deemed distribution at will, the transaction was not a loan it was a distribution.

I avoid loans whenever possible, they always create a headache.  It has gotten a little better with portability and the ability to repay after termination, but I never recommend loans when designing a plan,.

15 hours ago, Lou S. said:

If the sponsor is worried about wide spread participant loan fraud, don't offer loans.

Absolutely!  But it is also self-correcting.  Our loan policy (consistent with DOL guidance) says one defaulted loan on the books, and no more loans - until it's paid in full.  PERIOD.  Plus those pesky tax consequences.....

RBG, Thanks.

1 hour ago, RatherBeGolfing said:

As for why it is a big deal, some would argue that if a participant with a loan has the ability to create a default/deemed distribution at will, the transaction was not a loan it was a distribution.

No way! Maybe in collusive circumstances, but absent that, I don't see it.

8 minutes ago, Luke Bailey said:

RBG, Thanks.

No way! Maybe in collusive circumstances, but absent that, I don't see it.

Uh, yea, well we've seen people "try" to do this, and "advise" the plan sponsor against granting the loan in the first place.  I hate to say it, often it's an owner seeking a loan to make payroll or some other business expense, and that in and of itself raises issues about the ability of the borrower to make payments.  In other circumstances, we've seen participant take a principle residence loan, followed by 8 other people in the same location, all buying the same property.  Same with hardships.  Participants talk.  In one case, they shared the same "eviction notice" complete with the same typos.  It happens.

Hardships are evil too, but loans are "eviler."  ?

12 hours ago, QDROphile said:

Austin, I believe you. I had two different clients that adopted QDRO policies to disallow distributions to alternate payee until the participant was eligible. They had unusual experiences with sham divorces (the word got out) and their remedy was to lock up all alternate payees to take the temptation away. I am also aware of the phenomenon of credit junkies and plans that allow multiple loans. The money was borrowed as fast as repayments met the standard for borrowing again.

Had a case involving large DB plan. Participant's spouse had terminal cancer and participant had been cheating on her for years. Not high income family, facing foreclosure, medical bills, etc. Participant had moved out and was living with girlfriend who had somewhat higher income. Got a divorce and plan was amended to allow immediate distribution to alternate payee. Enabled AP to live out last couple of years of life not facing eviction for her and kids. Just saying there is another side to this.

MoJo, I'm just saying that unless the employer is colluding, there is no risk to the plan's qualification, and the participant gets the (deemed) distribution soon enough anyway.

1 minute ago, Luke Bailey said:

MoJo, I'm just saying that unless the employer is colluding, there is no risk to the plan's qualification, and the participant gets the (deemed) distribution soon enough anyway.

Two things.  Employers routinely outsource loan approval to recordkeepers.  So, no employer intervention, and unless the r/k spots something amiss among the thousands of loan requests received in a given period of time, the employer wouldn't know (and hence no collusion).  Second, there is "fiduciary" risk, regardless of plan qualification risk  

1 hour ago, Luke Bailey said:

No way! Maybe in collusive circumstances, but absent that, I don't see it.

Oh I agree with you, just saying that is the argument some will make.

About the fiduciary risk MoJo mentions, what if the plan’s governing documents provide, and all summaries and forms explain, that a decision about whether to take a participant loan (and how much), and a decision about whether to collect an amount due under a loan’s repayment provisions is a participant’s investment direction.

Would that set up an ERISA § 404(c) defense that a loss results from the participant’s exercise of control?

2 hours ago, MoJo said:

Second, there is "fiduciary" risk, regardless of plan qualification risk  

MoJo, I do not see fiduciary risk. First, there is the 404(c) argument as mentioned by Peter. Second, how would the participant ever be injured? One way or the other, they get their benefit (the plan asset), so there is never a loss. A fiduciary's responsibility to plan participants is with respect to the assets of the plan, not their life course.

1 hour ago, Luke Bailey said:

MoJo, I do not see fiduciary risk. First, there is the 404(c) argument as mentioned by Peter. Second, how would the participant ever be injured? One way or the other, they get their benefit (the plan asset), so there is never a loss. A fiduciary's responsibility to plan participants is with respect to the assets of the plan, not their life course.

I don't buy the 404(c) argument - nor the do I believe the DOL would.  This is not an "investment decision" by the participant, it's an "obligation" that the plan fiduciaries must create consistent with plan documents (including a loan policy) and 2) in a commercially reasonable manner.  Both have fiduciary implications.  Now, those conditions occur at the time the loan is issued - but it raises the issue as to 1) what steps do plan fiduciaries have to take to ensure compliance; and as a part of that 2) how much information should they gather, and what to do with information once gathered (whether intentionally or not).  In modern administration of a plan, recordkeepers handle most of that on an outsourced basis, and so 99.9% plus are non-issues.  But one does uncover nefarious attempts from time to time (we see one or two a month out of the thousands of loan requests that come in) when an attempt is uncovered we go back to the plan fiduciaries for a decision.

Keep in mind that this could be a loss to the PLAN, even though the participant isn't harmed.  Different responsibility, and one that triggers consequences for the asleep fiduciary.

As I said, as a percentage of loan requests that we receive, a handful are caught where it appears the participant is playing fast and loose with the rules.  Amazing though how many loans are defaulted without a single payment ever having been made....

1 hour ago, MoJo said:

Keep in mind that this could be a loss to the PLAN, even though the participant isn't harmed.

So assume a completely asleep at the wheel $50,000 loan from a $100k account that the participant pulls his or her withholding authorization for within a month and the loan is deemed. What is the loss to the plan? And assuming it is a loss in the amount of $50,000 and the employer says, OK, i will make that loss good to the plan, where do you put the money? Back in the account of the participant, who had no loss? In the rest of the plan, which was not impacted by the loan in any way? I've been down these rabbit trails before, and just don't see it.

We might never know whether a court would treat a loss of the kind this discussion describes as a loss that resulted from a participant’s exercise of control over her account.

Among other reasons, it’s unclear whether the participant would even get her day in court.  The U.S. Constitution might preclude a Federal court from considering a case if the plaintiff does not show: (1) that she suffered a concrete injury-in-fact, (2) that the defendant caused the injury, and (3) that her injury would likely be redressed by the requested judicial relief.

See, for example, Lujan v. Defenders of Wildlife, 504 U. S. 555, 560–561 (1992); see also Thole v. U.S. Bank N.A., No. 17-1712, 590 U.S. ___, slip op. at 4 (June 1, 2020) (“n order to claim ‘the interests of others [such as the employee-benefit plan], the litigants themselves still must have suffered an injury in fact, thus giving’ them “a sufficiently concrete interest in the outcome of the issue in dispute.’”).  https://www.supremecourt.gov/opinions/19pdf/17-1712_0971.pdf  (Thole is wrongly decided.  But it is precedent.)

In the third paragraph, I did not write the underlining, did not fail to write the ellipsis at the beginning of the quotation, and did not italicize the quotation, or my observation about it.

On 11/6/2020 at 5:57 PM, Luke Bailey said:

So assume a completely asleep at the wheel $50,000 loan from a $100k account that the participant pulls his or her withholding authorization for within a month and the loan is deemed. What is the loss to the plan? And assuming it is a loss in the amount of $50,000 and the employer says, OK, i will make that loss good to the plan, where do you put the money? Back in the account of the participant, who had no loss? In the rest of the plan, which was not impacted by the loan in any way? I've been down these rabbit trails before, and just don't see it.

Luke:  Let's not get too academic here - but until paid, the money (even though we "allocate it" to a participant's account" is NOT the property of the participant.  It is the property of the trust, and one of the requirements of trusts under ERISA is that "all" of the money is available at "all" times to pay the benefits promised.  DC plans make it seem like the money belongs to a specific participant, but "legally" it doesn't.  A loss of any one participant's account balance is by definition a loss to the plan.

3 hours ago, MoJo said:

Luke:  Let's not get too academic here - but until paid, the money (even though we "allocate it" to a participant's account" is NOT the property of the participant.  It is the property of the trust, and one of the requirements of trusts under ERISA is that "all" of the money is available at "all" times to pay the benefits promised.  DC plans make it seem like the money belongs to a specific participant, but "legally" it doesn't.  A loss of any one participant's account balance is by definition a loss to the plan.

MoJo, that's pretty academic!

2 hours ago, Luke Bailey said:

MoJo, that's pretty academic!

Guilty....