(b)lines Ask the Experts – Processing 403(b) Loan Defaults

“I realize that, once a participant defaults on a loan, it’s a deemed distribution and a 1099R is issued. But what should happen to the participant’s account? Is it reduced by said distribution? And what happens to the outstanding loan? Is interest still accumulating on the deemed distribution? How is such interest reported going forward?”  

Michael A. Webb, vice president, Cammack Retirement Group, answers:

Unfortunately, the Experts cannot provide answers to many of these questions, as such answers will vary according to the contract provisions of the vendor that issued the loan. Thus, it is extremely important to have a thorough understanding of the vendor loan agreements so that these issues may be addressed, and to contact the vendor if there is ambiguity. This is especially true in connection with defaults, due to the negative consequences of a loan default to a plan participant.

However, the Experts can make some general statements as to the consequences of loan defaults as stated in the loan regulations under Code Section 72(p), as follows:

1) A participant will not be able to re-borrow after default unless a) payroll deduction is permitted for loan repayments or b) secured by additional collateral held outside of the plan (a rare event in the Experts’ experience). However, see “Ask the Experts: Permitting Loans After a Loan Default” for an exception to this rule

2) Interest that accrues after a loan default will NOT result in additional deemed distributions reportable on a 1099R. However, accrued and unpaid interest following a loan default, will be considered part of the “highest outstanding balance in the prior 12-month period” in determining how much a participant may re-borrow if eligible for another loan.

3) If loan repayments are made following a loan default, such repayments will be treated as after-tax contributions to the plan. However, such contributions will NOT be subject to the nondiscrimination and other rules (e.g. contribution limits) that would normally apply to after-tax contributions. As after-tax contributions, such post-default loan repayments will not be taxable upon distribution.

Thank you for your questions, and be certain to examine your loan agreements thoroughly!