Advanced Distribution and Loan Issuesmedia01.commpartners.com/NIPA/2014/session6/Kaplan...Loan refinancing • Jim has $30,000 vested account balance • Outstanding loan: •Paid

Advanced Distribution and Loan Issues

Bob Kaplan, APA, CFP, CPC, QPA,

Vice President, National Training

Consultant, ING US

Robert M. Kaplan, APA, CFP, CPC, QPA Vice President, National Training Consultant, ING US

Bob Kaplan is the VP, National Training

Consultant for ING. His responsibilities include

web cast and live training for members of the

TPA and Financial Advisor community as well as

ING personnel.

He is currently a Co-Chair of the American

Society of Pension Professionals and Actuaries

(ASPPA’s) Government Affairs Committee. Bob is

a member of ASPPA’s Board of Director’s.


He previously served as a member of the Board of

Managers of the American Institute of Retirement

Education (AIRE) as well as the Board of Directors of

the National Institute of Pension Administrators (NIPA).

In 2009, Bob was presented with NIPA’s Lifetime

Achievement Award for his contributions to the

retirement plan industry.

Bob is a frequent speaker at industry events including:

• Annual conferences for ASPPA, NIPA, Western

Benefits Conference, AICPA, the American Bar

Association

• Chapter Meetings and webcasts for NIPA

• Benefits Counsels, webcasts and Regional Meetings

for ASPPA


He has provided testimony before the Treasury

department on 401(k) issues and other retirement

plan issues. Bob has over 34 years of experience

in retirement plan services, including plan design,

administration, sales and consulting.

Bob is also a former high school basketball

coach. He is a graduate of the State University at

Albany, NY and has a graduate degree from

William Paterson University in New Jersey.

Some Statistics

• Per Financial Literacy Center Working Paper

• 2007 = $600 million in deemed distributions (0.2% of plan assets)

• 80% of terminating employees with loans defaulted (based on study of 100,000 employees)

• Defaulters: • Larger loan balances than those that repaid

• Multiple loans more likely to default than single loan

Two Sets Of Statutory Rules

• Taxation requirements

(Code §72(p)).

• Prohibited transaction

requirements (Code

§4975) and DOL

Regs. • Loans must comply with both sets of

requirements

• Plan must authorize loans

• Plan loan provisions may be in more than one document

• Plan loan policy

Plan Documentation

Participant Documentation

• Loan note

• Irrevocable pledge and assignment

Violation of 72(p) Taxation Rules

• Consequences for violation

• Taxable (deemed) distribution to

participant

• Premature distribution tax if

employee is not 59½

Payment starting date

• Q: How far after the loan origination date does the

first payment need to start?

• The regulations do not specify

• The first payment should commence as soon as

administratively feasible after the participant receives

the loan proceeds

• TEFRA blue book suggests that plan has two months to

commence payments

• Predates TRA 86 changes

• Not incorporated into final regulations

5-year rule

• If promissory note term exceeds 5 years, loan is

immediately a deemed distribution

• Exceptions: purchase primary residence and USERRA

• Voluntary withholding applies

• Example (we have seen the IRS enforce this strictly):

Loan requested February 1

Check issued February 14

First payment March 10

5-year period begins February 14

Level Amortization

• Amortize principle and interest at least quarterly

• Missed payment will cause 72(p) violation

• Most common cause of deemed distributions

Grace (Cure) Period

• Plan can provide a grace period for missed payment

• Maximum: Last day of following calendar quarter

• Plan may use smaller grace period (e.g., 90 days or 30 days)

• Good to have some grace period. Otherwise, one day late = deemed distribution

Loan Default Reporting

• On 12/31/13, no payments since 8/1/13

• Plan defaults loan on 12/31/13

• Missed payments = $1,100; unpaid balance = $8,000

• What is the amount of her deemed

distribution?

• How should the employer report the loan

default?

• Does the deemed distribution create a basis in

her account

Reporting Default – 1099R

• Outstanding loan amount, not just missed payment

• Code L and 1 (if not 59½) in box 7

Loan offset

• Plan can offset defaulted loans prior to

employment termination if plan allows in-service

distribution • Plan can distribute on any stated event (such as loan default):

• Profit sharing

• match

• Plan generally can’t distribute in-service except at 59½:

• Elective deferrals

• QNECs, QMACs

• Safe harbor contributions

• No in-service distributions before 62

from pension

Date of loan offset

• Participant quits May 2014

• Loan balance is current

• No further payments made

• Calendar year plan

• Plan distributes balance in October 2014

• Loan offset takes place September 30, 2014

• Assuming plan allows maximum grace period

• Offset equals:

• Unpaid principal plus

• Interest accrued to date of offset

Post Default (Phantom Interest)

• Interest still accrues after deemed distribution

• Interest accrues until the loan is repaid or offset

• Phantom interest is neither taxable nor reportable

• However, phantom interest is still relevant

Conditions for New Loan After Deemed Distribution

• After deemed distribution, if old loan not repaid, there is

mandatory payroll deduction or additional collateral

• Some plans allow only one outstanding loan at a time

• Forces borrower to repay

defaulted loan in order to get new one

Phantom interest

Loan Balance $8,000

Phantom Interest $1,000

Total Loan Balance $9,000

Other Assets $30,000

Total Account $39,000

Loan Limit (50%

Account) $19,500

Max Loan (Limit –

Loan) $10,500

• Kathy - 100% vested

participant defaults on

$8,000 loan

• Plan reports deemed

distribution

• Plan accrues $1,000

phantom interest after

deemed distribution

• To repay entire loan, EE must repay loan + phantom interest

• EE obtains basis for repaid defaulted loan

• Not after-tax EE contributions — not subject to ACP test

Repayment of Defaulted Loan

• If plan cannot offset, loan remains on the books

• However, not on 5500 financials

• When distributable event occurs, plan may offset

• Plan does not report offset on 1099-R

• Not eligible for rollover

Offset Following Deemed Distribution

Loan refinancing

• Refinancing possibilities • Keep same ending date on loan but take out more money or

change interest rate

• Move repayment date • But if more than 5 years from ORIGINAL loan date then

• Old loan and new loan exist at the same time

• Must satisfy loan limits considering both • Any refinancing must be consistent with plan loan policy

• How does refinancing a loan work with the “1 loan at a

time rule”?

• This is a plan loan policy rule: not an IRS rule

• So change your loan policy so it says what you want it to say

• Example: 1 loan at a time, but a refinance is considered to be 1

loan, not 2

Loan refinancing

• Jim has $30,000 vested account balance • Outstanding loan:

• Paid down to $8,000 • 3.5 years left in repayment period

• Jim requests $15,000 w/ 5 year repayment

• Will use loan proceeds

to pay off $8,000 loan

Special Amortization

• First loan disregarded if new loan due 5 years from

original loan

• First loan disregarded if EE repays first loan within

original 5 year period, and repays replacement loan

during normal repayment period

• Mary borrows $10,000 @ 8% on 5/1/14 due 5/1/19.

Payment $203

• 5/1/15 balance is $8,300. Mary ($25,000 a/b) wants

new loan

• Mary borrows $12,500 @ 7%, paying old loan and

taking $4,200 cash. New loan due 5/1/19. Pays $282

until 5/1/19, and thereafter $83.

• Do the two loans violate the 50% limit?

Amortized as Two Loans

• Jim takes a $20,000 loan from his $40,000 a/b on

5/1/14

• Jim obtains hardship distribution one week following

loan

• Does Jim’s loan violate amount limitations under Code

§72(p)?

Hardship Distribution

Leave of Absence

• Plan may suspend loan payments for leave of absence

• One year maximum suspension

• Interest continues to accrue

• Does not extend 5 year repayment period

• Participant must repay within 5 years from original loan • Can extend to full 5 years

• Balloon payment or reamortization

Military Leave of Absence

• Plan may suspend for military service

• Entire period of military service, not just 1 year

• Military service does not count against 5 year repayment period

• Employee must repay loan and accrued interest by end of 5 year period not counting the military service. Can use full 5 years even if original loan was shorter – Can use same payments with a balloon at

the end

– Can increase payments to avoid balloon

Military Interest Rate

• During the period of military service, a plan cannot

charge more than 6% compounded annually on loan to

serviceman made prior to entering the service.

Serviceman must give notice to plan to claim this rule.

• The 6% limit includes all service or maintenance

charges.

• If you want to charge a higher rate, it requires a court

order.

Rollover of Loan Offset

• EE may roll over loan offset

• Procedure: EE contributes rollover amount out of his/her

pocket

Rollover of Loan Note to New Plan

• May roll over loan note to a plan if loan is not offset

• Direct rollover

• Plan may accept

• Plan must permit loan

• Assignment of loan

• Loan offset is eligible rollover distribution

• Subject to 20% withholding to extent

distribution includes cash in addition to

offset

• Withholding cannot exceed cash to

participant

Withholding Rules (Loan Offset)

• Susan terminates employment with

$100,000 account balance, including

$20,000 loan

– If Susan receives a distribution of her

entire account balance and the plan

offsets the loan, what is the taxable

amount reportable on the Form 1099-R?

– If Susan does not roll over any of the

distribution, how much should the

plan withhold?

Loan Offset – Taxation

– If she rolls over directly the $80,000 to an IRA and the plan offsets the loan, how should the plan report the distributions? How much should the plan withhold?

– If she rolls over $50,000 and the plan offsets the loan and distributes the balance of her account, how much should the plan withhold from the distribution?

Withholding/Reporting

• May she roll over her entire vested account

balance (including the loan note) to another plan?

IRA?

• Must the recipient plan accept the rollover of the

loan note? Must the receiving plan permit

participant loans to accept the rollover of the loan

note?

• May she use the 60-day rollover rule to effect a

rollover of the participant loan note?

• How does a plan effect a rollover of a participant

loan note?

Partial Rollover

Reasonable Interest Rate

• Commercially reasonable rate

• What a financial institution would charge for similar type of loan

• If reasonable interest rate would violate usury laws; plan should not offer loans

• What did IRS say about Prime +1?

Limiting loans to active participants by limiting loan repayments to payroll deduction

• Doesn’t work

• Plan can require actively employed participant to repay via

payroll deduction

• Prohibited transaction requirement: Loans available to

all participants and beneficiaries on reasonably

equivalent basis

• This includes former employees

• DOL Advisory Opinion 89-30A

• Plan can limit loans to parties-in-interest

• All employees are parties-in-interest

• Former employees generally are not parties-in-interest unless

they are owners or fiduciaries.

• So this limits loans to current employees and other parties-in-

interest

Acceleration of Payments

• Plan may provide for acceleration of loan upon

separation from service if employee is not a party-in-

interest

• Plan may accelerate upon plan termination

• Note should include acceleration clauses

Spousal Consent

• No J&S plan: no spousal consent

• J&S plan: need spousal consent

• Binding on subsequent spouse

Protected Benefit

• Loans are not

protected benefit

• Employer may eliminate loans

• Transaction: ER’s retention of participant loan

repayments longer than plan asset rules permit

• Correction: pay to plan Principal Amount plus greater

of Lost Earnings or Restoration of Profits – Principal Amount = amount of delinquent contributions.

– Loss Date: date contribution reasonably

could have been segregated (not later than

15th bus day)

– If contributions were paid, but late: just

pay greater of Lost Earnings or

Restoration of Profits

Delinquent deposit of loan repayments

Failure to withhold loan repayments

Issues: Operational failure

Fiduciary breach

Triggers deemed distribution

VCP offer: We’ll forgive the operational failure

In most cases, we’ll forgive deemed distribution

Alternatively, we’ll postpone it

VFCP correction method: Go through VCP

ER contributes interest which accrues because of

failure to withhold

Greater of plan loan rate or plan earnings rate

Participant still must repay principal and interest under

note by either

Making lump sum repayment = missed payments

Reamortizing loan over remainder of original term

Can extend up to original 5-year period

Combination of above

Failure to withhold loan repayments: Correction

I borrow $10,300 May 1, 2014 6.25%

Pay $100 from each semi-monthly paycheck

Last payment April 30, 2019

January 3, 2015 we realize no withholding

Consequences: If no VCP, loan defaulted

Deemed distribution September 30, 2014

(if not sooner)

I get 2014 1099-R for $10,849 (outstanding

balance September 30, 2014)

Loan example

Loan Example Correction

Balance 12/31/2013 $11,192.69

Payments I owe $1,600.00

12/31/2013 balance if payments timely $9,528.65

Interest ER should pay $64.04

My repayment options: Pay $1,600 and ER withholds $100/paycheck as planned

ER withholds $138.86/paycheck until

April 30, 2018

Something in between

Borrower in best position to avoid problem

The BORROWER is responsible for making certain that the employer is withholding the proper loan payments. If the BORROWER determines that a loan payment has not been withheld, the BORROWER must notify the employer and arrange for a make-up loan payment(s) before a default occurs. If the BORROWER does not make the missed loan payment(s) and a default occurs, the BORROWER will be subject to adverse federal income tax consequences.

An ounce of prevention . . .

• Many plans require payroll withholding as a condition

for receiving the loan

• After obtaining loan, may participant terminate the

withholding agreement? • State law generally permits EEs to terminate withholding

agreements (except for taxes, child support)

• Preemption: DOL and courts have not addressed

• Regs require plan to use payroll withholding or obtain

additional collateral if participant

obtains a loan when he/she has an outstanding defaulted loan

Terminating Payroll Withholding

• Issue: If you allow the participant to terminate

withholding, loan almost certainly will default

– Plan will need to administer a loan that it probably cannot

offset until participant terminates

– Off the 5500 financials but on the plan books

– Participants may discover this as a method for circumventing

the distribution restrictions

• Two alternative approaches:

– Hard line: we believe ERISA preempts state law and unless

participant raises state law and threatens plan with litigation,

we will not allow you to terminate withholding

– Conservative: If you ask us to terminate, we will

• Place restriction on future loans?

Payroll Withholding

Bankruptcy: Plan loans not subject to auto stay

• BK courts had ruled that BK automatic stay allowed court

to order ER not to withhold from payroll to repay plan

loan

– EE essentially repaying himself/herself to detriment of creditors

• 2005 law reverses:

– ER can continue to withhold and pay to plan

– Doesn’t apply to payments directly from debtor

• Applies to loans:

– Subject to ERISA participant loan PT exemption,

or

– Subject to Code §72(p)

• Chapter 13 plan can’t alter plan loan terms

• Plan loan repayment amounts aren’t “disposable

income” for Chapter 13 – Don’t have to figure into Chapter 13 analysis

• But many courts find that retirement plan loans aren’t

“secured debt” for Chapter 7 (liquidation) – May force debtor to go to Chapter 13

• Plan loan excepted from discharge – Combined with relief from stay, means

debtor doesn’t have taxable deemed

distribution because of BK and can

continue loan repayment

Loan exemptions

• Not taxable to the beneficiary

• Not beneficiary’s liability

• Options:

• Offset

• Payment stops

• Loan accelerated (see loan policy)

• Estate pays off loan

• Estate (or beneficiary) continues paying loan

Loan: Death of a Participant

• Optional under terms of plan document

• Plan may use “facts and circumstances”

or “safe harbor” reasons

• Must be immediate and heavy financial

need

• 401(k) regulations - §1.401(k) – 1(d)(3)

Hardship Distributions

• Amount may not exceed amount needed to satisfy

hardship

• But may be trued up for taxes and penalties


• Safe Harbor definitions:

• Medical care deductible under Tax Code §213(d)

• Purchase of principal residence (excluding

mortgage payments)

• Post-secondary education (next 12 months)

• Prevent eviction or foreclosure from principal

residence

• Funeral expenses

• Casualty deduction home repairs


• Principal residence

• IRS has opined:

• Purchase of residence for family members but

NOT the employee would not be allowed

• Purchase of house from an ex-spouse would be

allowed

These opinions were expressed at industry

functions and are not part of the regulations


• Beneficiaries who incur hardship may

qualify

• Must be primary beneficiary

• Must be at time that the hardship occurred

(cannot change beneficiary designation after

the hardship)

• Applies to medical, education, funeral

expenses


• Participants may need to be reminded

that hardships are subject to taxes and

penalties (unless an exception applies)

• In 2008 Presidential campaign, Obama

proposed penalty relief for lesser of

$10,000 or 15% of withdrawal

• No action on this yet


• Suspension of deferrals may apply

• Plans that use “safe harbor”

• Must be six months for Safe Harbor match

plans

• May be up to 12 months for other plans

• Always see the plan document for verification


• Proof of hardship

• Not defined in regulations

• 2008 ASPPA Annual conference IRS

stated that plan administrator must have

“sufficient information to adjudicate a claim

– see regulations relating to Katrina”

• My advice – paperwork now can save a lot

of hassle after the fact if an audit or

questions occur


• Does an immediate and heavy

financial need exist?

• For this part of the process a plan

administrator may rely on the

representations of the employee (and not

demand proof)

• Unless “knowledge to the contrary”


• Rules require that all other

distributions and nontaxable loans

from all plans of same employer be

taken first

• This does not mean that all plans must

have a loan provision


• Loan does not have to be taken if it

will be “Counterproductive”

• If it will increase hardship such as

preventing a third party loan (mortgage for

primary residence) or take home pay

would be lowered too much

• There is no criteria in regulations for this

• Documentation should be kept


• Limited to aggregate deferrals (and

not earnings) after 1988

• Question: What if you have a takeover

client and were not provided with a

breakdown of deferrals/earnings??


• Roth deferrals are allowed to be taken

for hardship

• But tax ramifications will be different

since this is after-tax money


• Rules can be extended to employer

contributions but not QNECs, QMACs

or Safe Harbor contributions

• Procedures should be established

under each plan as to which source is

used first


• Participant is 5 months behind in mortgage payments

• Receives letter threatening foreclosure

• Needs $5,000 for late payments, legal fees and bank fees associated with foreclosure

• Real estate taxes of $1,800 are due next month

• Can’t make next two payments totaling $1,200

• Question: Can he take one hardship instead of three (to save on distribution expenses)


• Plan Administrator needs to consider:

• The 12 month in advance rule that applies to tuition does not

apply to other hardship reasons

• No specific IRS guidance on this matter

• If you allow two months –where is the line drawn, at three, four,

twelve?

• Need to look at the immediate and heavy financial need. If Plan

Administrator is comfortable that documentation will be sufficient

in an audit situation

• Bob’s caution – if the foreclosure has not been threatened

because of the taxes and future payments the criteria may not be

satisfied. How threatening is the letter about future payments?


• Plan Administrator needs to consider:

• The 12 month in advance rule that applies to tuition does not

apply to other hardship reasons

• No specific IRS guidance on this matter

• If you allow two months –where is the line drawn, at three, four,

twelve?

• Need to look at the immediate and heavy financial need. If Plan

Administrator is comfortable that documentation will be sufficient

in an audit situation

• Bob’s caution – if the foreclosure has not been threatened

because of the taxes and future payments the criteria may not be

satisfied. How threatening is the letter about future payments?


Thanks for joining us

Advanced Distribution and Loan Issuesmedia01.commpartners.com/NIPA/2014/session6/Kaplan...Loan refinancing • Jim has $30,000 vested account balance • Outstanding loan: •Paid

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