Considering a Loan Cure Period to Avoid Participant Loan Defaults

Defined contribution (DC) plan participant loan defaults can be a big setback to retirement savings.

A Deloitte analysis found a typical defaulting borrower could lose $300,000 in retirement savings over his career. This includes taxes, early withdrawal penalties, lost earnings and, for terminated or retired participants, any early cash-out of a defaulting participant’s full plan balance.

For participants who terminate employment or retire, some plan sponsors have adopted the ability for participants to continue to make loan repayments after termination, and when loan repayments are payroll deducted, it is less likely active participants will default on loans. However, there are still situations in which active participants may default.

One solution plan sponsors can consider is allowing for a loan cure period. The IRS says in a recent Issue Snapshot that a plan sponsor may, but is not required to, allow a cure period during which a delinquent participant loan may be brought back into compliance without triggering a deemed distribution. If allowed, the cure period must be specifically provided for in the written plan document.

If this option is adopted, the maximum allowable cure period would extend to the last day of the calendar quarter following the calendar quarter in which the required installment payment was due. The plan sponsor may also adopt a shorter cure period, or none.

If a loan repayment is still late even after considering the cure period, the amount of the deemed distribution is equal to the entire outstanding balance of the loan (including any accrued interest) as of the last day of the cure period.

The IRS offers examples of how a loan cure period works. In the first, participant A is in Year 2 of the loan repayment schedule when she misses two payments (March and April). She then makes two timely payments (May and June) before catching up with a triple payment in July.

The two missed installment payments (March and April) have separate cure periods because they occur in separate calendar quarters (June 30 for the March payment and September 30 for the April payment). Each missed installment is cured by the timely installment payments made in May and June of Year 2, which are shifted to cover the missed installments.

By shifting the May and June installment payments to cover the March and April missed installments, the May and June installments are then considered missed. However, by making the triple installment payment in July, the May and June payments are timely cured.

In the IRS’ second example, Participant A is in Year 2 of the loan repayment schedule when she misses four payments (March, April, May and June). On July 3, she makes a double payment equal to the missed March and April installments. The make-up installment payment was received after the end of the cure period for the March installment. As a result, Participant A has a deemed distribution on June 30. The amount of the deemed distribution is the outstanding loan balance (including accrued interest) on June 30. However, because she made loan repayments after the deemed distribution occurred on June 30, the participant has an investment in the contract (tax basis) equal to the amount of the payment made on July 3.

The IRS offers another example in which the participant timely refinances her loan within the cure period, avoiding a deemed distribution.

Especially in this time, when the coronavirus pandemic may cause work interruptions, allowing a cure period for plan loans may help preserve participants’ retirement savings. The Department of Labor (DOL) has said it considers participants’ loans as plan investments, so plan sponsors should consider their fiduciary duties as they do with other plan investments.