Loan Limit, Hardship, and Default at Termination
Priya participates in a 401(k) plan with a vested account balance of $120,000. She has an outstanding loan with a balance of $10,000; the highest outstanding balance during the prior 12 months was $12,000. The plan permits one new loan per calendar year, a maximum loan term of five years, and loans up to the lesser of 50% of the vested balance or $50,000 reduced by the highest outstanding loan balance in the prior 12 months. On August 1, 2025, Priya requests a new loan of $42,000 for a primary-residence down payment. She also submits a hardship request for $15,000 for her dependent's college tuition. The plan permits hardship withdrawals for tuition and permits both loans and hardships. The plan document requires that a participant exhaust all available plan loans before receiving a hardship distribution. Priya is 45 and does not qualify for any penalty exception other than higher-education expenses.
1. What is the maximum new loan Priya can receive, and how should the administrator handle her $42,000 request?
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The statutory loan limit is the lesser of 50% of the vested account balance ($60,000) or $50,000 reduced by the excess of the highest outstanding loan balance in the prior 12 months over the current balance. The maximum total loan balance is $50,000 − ($12,000 − $10,000) = $48,000. Because $10,000 is already outstanding, the maximum new loan is $48,000 − $10,000 = $38,000. The administrator should approve no more than $38,000 and explain the reduction to Priya. A $42,000 loan would cause the total outstanding balance to exceed the statutory limit, which would make the loan a deemed distribution under IRC §72(p). The administrator should not simply process the requested amount and rely on payroll to catch the excess.
2. How should the plan evaluate the $15,000 hardship request given the loan availability and the plan's exhaustion requirement?
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Because the plan requires exhaustion of all available plan loans, Priya must first take the $38,000 loan. That loan exceeds the $15,000 tuition cost, so after taking it she has no remaining immediate and heavy financial need for the tuition. The plan may therefore deny the hardship request as unnecessary. If the plan instead permitted a hardship without loan exhaustion, the administrator would still need to confirm that the $15,000 is for tuition for a dependent, is not more than the amount needed, and that Priya has no other available distributions. The plan may rely on her written representation unless it has actual knowledge to the contrary. The administrator should document the loan first, the tuition bill, and the denial rationale.
3. Six months later Priya terminates with $30,000 of loan principal outstanding. What happens to the loan, and how is it reported?
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On termination, the plan may offset the loan against her vested account balance if the plan documents permit offset at termination. The offset is a distribution to Priya. If the loan is not repaid or rolled over, the offset is taxable in the year of offset and is reported on Form 1099-R. Because Priya is 45, the 10% additional tax under §72(t) applies unless an exception applies; a loan offset is not itself an exception. The offset is an eligible rollover distribution, so the plan must give her the §402(f) notice and a direct rollover opportunity, and 20% mandatory withholding applies to the taxable amount unless she elects a direct rollover. The plan should issue the 1099-R with the correct distribution code and report the offset on the Form 5500. The administrator should also check the plan's grace period and whether the loan was in default before termination.