Many defined contribution plans include provisions for a participant to take a loan from their account balance. The loan is generally limited to $50,000 or 50% of the participant’s vested account balance, whichever is less and may also be subject to a minimum. Loans are typically repaid through payroll deduction over a period of 5 years, sometimes longer if used for purchasing a home. The repayment terms include interest at a reasonable rate and have default provisions, just like a commercial loan. It is these default provisions that can get a Plan Administrator into trouble.
While each plan’s loan policy can be different, for purposes of this article we will focus on the following as a sample policy:
The Administrator shall treat a loan in default if (a) any scheduled repayment remains unpaid at the end of the calendar quarter following the calendar quarter in which the participant missed the scheduled payment or (b) there is an outstanding principal balance existing on a loan after the last scheduled repayment date.
Upon default, the entire outstanding principal and accrued interest shall be immediately due and payable. If a distributable event has occurred, the Administrator shall direct the TPA to foreclose on the promissory note and offset the participant’s vested interest in his/her account by the outstanding balance of the loan. If a distributable event has not occurred, the Administrator shall direct the TPA to foreclose on the promissory note and offset the participant’s vested interest in his/her account as soon as a distributable event occurs. The TPA shall have no obligation to foreclose on the promissory note and offset the outstanding balance of the loan except as directed by the Administrator.
Determining whether a default has occurred is relatively easy by reviewing payments and due dates. The challenging part is in monitoring the loans and determining whether a distributable event has occurred. A distributable event in most plans is a separation from employment. Some plans also include reaching age 59½ or total disability. It is important to understand your plan’s definition of a distributable event.
Another key item to notice in our sample policy is the assignment of duties. Notice that the TPA is not responsible for this process. The Plan Administrator is responsible for reviewing loans, noting whether a default has occurred, and instructing the TPA to foreclose on the loan. What happens in a lot of plans is the Plan Administrator is not doing their part and loans that should be foreclosed instead sit on the books, unpaid and accruing interest.
So why does it matter? Let’s break down the plan accounting based on each scenario covered in our sample policy:
If a distributable event has occurred, the Administrator shall direct the TPA to foreclose on the promissory note and offset the participant’s vested interest in his/her account by the outstanding balance of the loan plus accrued interest through the date of default.
In this scenario, the loan is offset against the participant’s account and the participant receives a 1099-R for a taxable distribution equal to the remaining principal plus accrued interest. The offset is recorded as a distribution and the participant loan is removed from the books. End of story.
If a distributable event has not occurred, the Administrator shall direct the TPA to foreclose on the promissory note and offset the participant’s vested interest in his/her account as soon as a distributable event occurs.
In this scenario, the loan considered a “deemed distribution” and the participant receives a 1099-R for a taxable distribution equal to the remaining principal plus accrued interest. The loan amount is recorded as a deemed distribution and the participant loan is removed from the… Form 5500. That’s right, the loan stays on the books because it is still outstanding and is still technically required to be repaid. In addition, the loan continues to accrue interest until a distributable event occurs. But now you are keeping two sets of books: one for the 5500 and one for plan accounting.
It gets even more complicated. The loan that has been deemed distributed still counts as an outstanding loan for purposes of determining a participant’s eligibility for a new loan under the plan’s loan policy. If your plan’s loan policy restricts a participant to one outstanding loan at a time, this will prevent them from being able to take a new loan. In addition, if the participant makes payments on the loan after it is in default and has been treated as a deemed distribution, then the repayments give the participant tax basis in their account. This means that somebody (the TPA?) needs to keep track of that basis in order to determine the non-taxable portion of future distributions.
How does this happen? Sometimes payroll errors result in loan payments not being made timely. A participant gets moved to a new division and in the process of changing the payroll setup, the deduction for the participant loan payment is forgotten. Sometimes the loan deductions from payroll are never started, due to an oversight or miscommunication between the TPA and the payroll department. More commonly it happens because the Plan Administrator isn’t monitoring the status of participant loans and working with the TPA to ensure they are accounted for properly.
How do you avoid the pitfalls of loan defaults? Here are some recommendations:
- Include in your loan policy a requirement for participant loans to be repaid via payroll deduction. Then you won’t have to worry about participants sending in repayment checks.
- Review the participant loan detail at least quarterly and identify loans that have fallen behind on payments. Determine why the payments stopped. If there was a payroll error you may be able to get the payments started again before a default occurs. Be aware however, that in this case the loan needs to be re-amortized and all remaining loan payments increased to make up for the lapse.
- If payments stopped because the participant separated from employment, WOOHOO! You have a distributable event. You should instruct the TPA to offset the loan and proceed with the necessary paperwork to ensure the 1099-R is provided.
- If payments stopped because an individual was on a leave of absence, there are some situations under EPCRS that will give relief to the participant under the VCP program. Consult your TPA for guidance.
- If payments stopped but no distributable event has occurred and you are unable to get the payments restarted within the cure period, instruct the TPA to proceed with treatment of the loan as a deemed distribution.
- Continue to monitor your list of loans that were deemed distributed and be on the lookout for distributable events for those individuals so that the loans can be foreclosed and removed from the books.
Participant loan programs allow participants to have access to retirement funds when needed, but they also come with a fair amount of administrative responsibilities for the Plan Administrator. The hiring of a TPA does not relieve the Plan Administrator of their responsibilities and most TPA’s leave the decisions regarding defaulted loans up to the Plan Administrator. Make sure you understand the responsibilities of both parties within your service provider agreement.
If you have any questions regarding this article or other issues related to your retirement plan, please contact your client service representative at BeachFleischman, or contact CariAnn Todd, the Director of our Employee Benefit Plan Audit group via email, email@example.com or directly at (682)203-6556.