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Question 32 — Processing 403(b) Loan Defaults

Q. How are 403(b) loan defaults processed? Once a participant defaults on a loan, it’s a deemed distribution and a 1099R is created. But what should happen to the participant's account? Is it reduced by the distribution? If not, what happens to the participant’s account and the outstanding loan? Is interest still accumulating on the deemed distribution? How is this reported? What are the best practices?

A. The defaulted loan must be “held” on the company’s books until the participant is eligible for distribution (e.g., age 59½, or severed employment). During that time, the IRS requires that the company continue to accrue interest on the defaulted amount, strictly for the purposes of determining future eligibility for loans. However, some companies will actually continue to charge that interest against the remaining account value. Other companies will treat it was “phantom” interest; not actually reducing the remaining account value. Once a distributable event occurs, the loan can be “taken off the books,” meaning actually distributed. At that time, the account value is reduced by the amount distributed. Note that actual distribution of a defaulted loan does not create a taxable event since the amount has already been reported as taxable. 

NTSA appreciates comments, especially from product providers, on how they are administering defaulted loans, since procedures might vary!