401(k) loans may seem like a nice way for plan participants to access money from their 401(k) plans prior to retirement. The drawback is that many participant loans can go bad if, at any time during their duration, they fail to satisfy any one of the IRS rules… no matter how insignificant or well-intentioned the oversight might seem. This can lead to taxes, penalties and administrative burdens for both you (as plan participant) and the plan.
When you miss a regularly scheduled loan payment, the loan technically goes into default. When a loan is in default, some sort of correction is required, but the loan has not yet reached a problematic point.
Loan regulations provide a “cure period” for making up a missed loan payment. It extends through the end of the calendar quarter, following the quarter in which the default occurs. In other words, once you miss one or more payments, you have until the end of the following quarter to make up the shortfall, along with accrued interest, to cure the default and prevent a deemed distribution.
A deemed distribution is when some or all of the outstanding balance of a loan is treated as a taxable distribution to the participant. This can occur either when a defaulted loan is not cured by the end of the cure period or when a loan is otherwise defective in some way.
Frequently Overlooked Aspects of Deemed Distributions
- There is no action required to trigger the tax liability. Just like a person’s paycheck is subject to income tax, regardless of whether they get a W-2 at the end of the year, a deemed distributed loan is taxable even if no one takes steps to report it on a Form 1099-R. If you don’t report the amount in question on your income tax return, you could face additional penalties and interest for underpayment of income tax.
- A deemed distribution does not extinguish your obligation to repay the loan. In other words, a deemed distributed loan is taxable (and may include a 10 percent early withdrawal penalty), but you must still repay it. To make matters worse, those post-deemed-distribution loan payments create tax basis in the plan and must be tracked as a separate money source on the recordkeeping system.
- A deemed distributed loan continues to be included as a plan asset until you have a distributable event, usually termination of employment. At that time, the outstanding balance is offset and reported on the plan’s financial statements as an actual distribution.
The Importance of a Loan Policy
If your plan allows for 401(k) loans, make sure that you have a loan policy in place, and that loans are being administered in accordance with that loan policy. Many issues can occur when reviewing loans at the end of the year. Some of the failures include:
- Loans are not permitted, and a plan issued a loan to a participant.
- Loan refinancing is not allowed and the plan allowed a participant to refinance their loan, or the refinancing was done improperly.
- The loan term was too long. The only circumstance in which a loan may exceed the length of five years is if a plan loan is issued to a participant for the purchase of a principal residence. This is the only exception to the 5 year payback rule.
- Payments are never started. This often occurs because of a disconnect with the payroll provider.
- Payments are voluntarily suspended or discontinued. If an employee can no longer afford to make payments, the employer may not stop their withholding for a temporary or permanent basis. Even though the participant is borrowing from his or her own account balance, the loan is still considered an asset of the plan. By voluntarily discontinuing the withholding of payments, the plan sponsor fails to enforce a legal agreement between the plan and the participant and allows a plan asset to decrease in value.
The good news is that many of the loan failures addressed above may be fixed through the IRS Employee Plans Compliance Resolution System. However, this program does not allow for self-correction of loan problems. So the correction of a loan issue under the program requires a submission of documentation to the IRS for approval. If you believe your plan may have any type of loan issue described above, contact your 401(k) plan third-party administrator for guidance on correcting the problem.
This article was originally published in Illuminations: Facts & Figures from people with a brighter way, a Rea & Associates enewsletter, 7/31/2013.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.