(b)lines Ask the Experts – Permitting Loans After a Loan Default

September 17, 2013 (PLANSPONSOR (b)lines) – “Our 403(b) plan vendor has been permitting plan participants to reborrow from the plan after they have already defaulted on a prior loan.

“When I questioned the vendor about this (our plan does not offer payroll deductions, so I thought such loans would be prohibited), the vendor responded that such loans are permitted since the vendor contract is a ‘special contract.’ What in the world does that mean?” 

Michael A. Webb, Vice President, Retirement Plan Services, Cammack LaRhette Consulting, answers:

The Experts would not have used the term “special contract,” but we think we know the contractual rule to which the vendor was referring. The final regulations under 72(p) included a provision that stated a participant who had defaulted on a loan could not reborrow from the plan unless a) loan repayments were made by payroll deduction or b) secured by additional collateral held outside of the plan (a rare event in the  Experts’ experience).

So why is your vendor continuing to permit such defaults? The answer is most likely the contract from which loans are being made was in effect prior to January 1, 2004, and permitted loans prior to that effective date. There is a grandfathering provision in the regulation that permits such contracts to continue to permit reborrowing after loan defaults without the payroll deduction requirement. Thus, rather than the term “special contract,” a more accurate term for the vendor representative to use would be “grandfathered contract.”

Some vendors did not choose to take advantage of the grandfathering provision and do not permit reborrowing without payroll deduction in the event of a loan default regardless of when the contract was issued. However, some vendors do take advantage of the grandfathering provision, and it appears your plan’s vendor is doing so.

If you do not wish to permit such loan utilization after a default, what can you do as a plan sponsor? Just because this is a contractual provision does not mean it needs to be the PLAN provision. You could amend your plan document (or your plan’s loan policy document, as applicable), so the plan will prohibit any participant from initiating a new loan after a loan has been defaulted. Of course, you will need to check with your vendor to make certain it can administer such a provision despite its contract language to the contrary.


NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.