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401k Loan - Deemed Distribution Date?


Gannuscio

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Hello Everyone,

I just received a notice from the IRS today that I was somewhat expecting. With that said, I believe the organization that issued the original 1099 has the year wrong.

Scenario:

I worked for company ABC for 7 years and took out a 401k loan. I was making regular payments through my paycheck until I left this company at the end of July 2013.

I never did receive a 1099 and actually forgot about it until I got the 1099 in May of 2014. (This is when I knew I would be expecting a bill from the IRS in the future)

I received the bill today in regards to my 2014 taxes. I believe the distribution from my 401k loan should have been on 12/31/2013 (for my 2013 taxes) based on the following:

Per the IRS: "For example, if the quarterly payments were due March 31, June 30, September 30 and December 31, and the participant made the March payment but missed the June payment, the loan would be in default as of the end of June, and the loan would be treated as a distribution at the end of September. "

I currently have the organization that managed my 401k doing 'Research' because they were not able to give me answers over the phone.

Can someone confirm whether I am correct or wrong?

Thanks in advance.

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I think the ABC company got it right. Your loan would've been defaulted at the end of the calendar quarter following the calendar quarter in which the first payment was missed (or you terminated employment and failed to pay the loan current).

So, you terminated employment in the quarter ending September 30th. The end of the following quarter would've been December 31st. No payment by that time would've become a taxable event shortly afterward (in 2014). That's a typically process. When the loan default date is the last day of a taxable year, then it's only reasonable that there is a delay. As a practical matter, many last week of December payrolls are actually processed in early January. So, the recordkeeper would have no confirmation as to whether or not a payment was actually made by December 31st until December 31st has actually passed.

If it was your desire to have this amount taxed in 2013, you could've made a distribution request have termination to have your loan treated as an offset distribution. You did not have to wait for the ABC company to act.

Good Luck!

CPC, QPA, QKA, TGPC, ERPA

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We would have defaulted this loan in 2013.

Something about the IRS description didn't seem right and I researched it...I think 2013 is right but someone please correct me if I'm wrong. (Assuming the maximum grace period "end of the quarter following the missed payment.")

The IRS description from the original post...

"For example, if the quarterly payments were due March 31, June 30, September 30 and December 31, and the participant made the March payment but missed the June payment, the loan would be in default as of the end of June, and the loan would be treated as a distribution at the end of September. "

...comes from Retirement Plans FAQs regarding Loans

(I don't get the part about defaulting at the end of June and being treated as a distribution at the end of September. That doesn't make sense.)

It references Reg. Section 1.72(p)-1, Q&A-10(a), which includes this example:

Example.
(i) On August 1, 2002, a participant has a nonforfeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over 5 years in level monthly installments due at the end of each month. After making all monthly payments due through July 31, 2003, the participant fails to make the payment due on August 31, 2003 or any other monthly payments due thereafter. The plan administrator allows a three-month cure period.

(ii) As a result of the failure to satisfy the requirement that the loan be repaid in level installments pursuant to section 72(p)(2)©, the participant has a deemed distribution on November 30, 2003, which is the last day of the three-month cure period for the August 31, 2003 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 2003. Alternatively, if the plan administrator had allowed a cure period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 2003 equal to $17,282, which is the outstanding balance of the loan at December 31, 2003.

In this example, the default and the deemed distribution occur on the same day, November 30, 2003. In fact they go on to say that if the plan used a cure period of the end of the following quarter, the deemed distribution would be on December 31, 2003. This lines up almost perfectly with the original poster's situation (replace "2003" with "2013").

Ed Snyder

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We would have defaulted this loan in 2013.

Something about the IRS description didn't seem right and I researched it...I think 2013 is right but someone please correct me if I'm wrong. (Assuming the maximum grace period "end of the quarter following the missed payment.")

The IRS description from the original post...

"For example, if the quarterly payments were due March 31, June 30, September 30 and December 31, and the participant made the March payment but missed the June payment, the loan would be in default as of the end of June, and the loan would be treated as a distribution at the end of September. "

...comes from Retirement Plans FAQs regarding Loans

(I don't get the part about defaulting at the end of June and being treated as a distribution at the end of September. That doesn't make sense.)

It references Reg. Section 1.72(p)-1, Q&A-10(a), which includes this example:

Example.
(i) On August 1, 2002, a participant has a nonforfeitable account balance of $45,000 and borrows $20,000 from a plan to be repaid over 5 years in level monthly installments due at the end of each month. After making all monthly payments due through July 31, 2003, the participant fails to make the payment due on August 31, 2003 or any other monthly payments due thereafter. The plan administrator allows a three-month cure period.

(ii) As a result of the failure to satisfy the requirement that the loan be repaid in level installments pursuant to section 72(p)(2)©, the participant has a deemed distribution on November 30, 2003, which is the last day of the three-month cure period for the August 31, 2003 installment. The amount of the deemed distribution is $17,157, which is the outstanding balance on the loan at November 30, 2003. Alternatively, if the plan administrator had allowed a cure period through the end of the next calendar quarter, there would be a deemed distribution on December 31, 2003 equal to $17,282, which is the outstanding balance of the loan at December 31, 2003.

In this example, the default and the deemed distribution occur on the same day, November 30, 2003. In fact they go on to say that if the plan used a cure period of the end of the following quarter, the deemed distribution would be on December 31, 2003. This lines up almost perfectly with the original poster's situation (replace "2003" with "2013").

It depends on the plan document. The MAXIMUM cure period is by the end of the calendar year quarter following the calendar year quarter where the payment was missed. As ETA says, a missed payment in the quarter ending September 30 would need to be cured by December 31. Practically speaking, I think most companies would default AFTER confirmation of no payment on December 31, which in this case would be in 2014. I think you can argue that it could be defaulted on December 31 because no payment was made on or before December 31, but I don't think either is necessarily wrong, it just comes down to procedure.

Now, a plan document could specify a shorter cure period as well, like your example with a November 30 cure date for a August 31 missed payment with a 3 month cure period (which is less than the maximum cure period)

 

 

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Hi All,

Great feedback, thanks much. As an outsider of the benefits world, they definitely don't make this stuff easy to understand. To me the difference is $6,500 in a tax bill which is pretty significant. I am trying to dig up the plan documents to see what the cure period says which may provide more relief.

With that said, I will also reach out to IRS to get their thoughts.

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I understand about the maximum cure period.

My point, maybe lost by being too wordy, is that the IRS FAQs were wrong, IMO. They referenced the regs which do not support the conclusion in the FAQs (default end of June/deemed distribution end of Sept - that's...weird).

As far as "practically speaking" I don't believe the systems limitations of recordkeepers should dictate taxation. The example in the reg is pretty clear about this being a 2013 taxable event.

Good luck Gannuscio!

Ed Snyder

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Hi All,

Great feedback, thanks much. As an outsider of the benefits world, they definitely don't make this stuff easy to understand. To me the difference is $6,500 in a tax bill which is pretty significant. I am trying to dig up the plan documents to see what the cure period says which may provide more relief.

With that said, I will also reach out to IRS to get their thoughts.

Look for documentation that was provided when you took the loan. It should be in your loan procedures which was probably part of your loan application.

Good luck!

 

 

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Hi All,

A quick follow up question. I have gone through most of my 401k documentation and the only thing I can find related is the following statement from Charles Schwab:

"If you have an outstanding loan from the Plan, your Plan benefit may be offset by the amount of the loan, typically when your employment ends. The loan offset amount is treated as a distribution to you at the time of the offset and, if the distribution is a nonqualified distribution, the earnings in the loan offset will be taxed (including the 10% additional income tax on early distributions, unless an expection applies) unless you do a 60-day rollover in the amount of the earnings in the loan offset to a Roth IRA or designated Roth account in an employer plan"

Question: Is this the 'Plan Document' language or should I be looking somewhere else?

Thanks in advance.

Brian

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Ask the company that manged the 401k plan to send you a copy of the Summary Plan Description, Loan Procedures, and your Promissory Note. One of those documents should have the specific language you're looking for, if not all 3.

FWIW I would have issued the 1099 in 2014, as well, based on the maximum cure period which is the option we use.

Regarding your $6500 liability - are you saying that you would have owed $6500 less if this were taxable in 2013?

R. Alexander

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Thanks for the info, I will send in a request for that. In terms of your question, yes I believe my tax liability would be around $6500 less if the income was taxable in 2013. In 2013, I didn't make nearly as much as I did in 2014 and with the additional income for 2014, I lost several deductions.

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Hey all,

Just an update. Charles Schwab is now telling me on the phone this is not a 'Deemed Distribution' as a 'Deemed Distribution' will only happen with a current employee that stops making payments on a 401k loan. I asked him what he called it and he said he was going to do research and now I'm on hold.

I just don't understand how it take someone completely from the outside (IT world) to try to figure this stuff out. If it's not a 'Deemed Distribution' what would it be called? Is it treated any differently if you are a current / prior employee on defaulting on a 401k loan?

Thoughts?

Thx

Brian

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He's also telling me there are no rules on when they have to 'Default' on the loan. My response was, "so you could default 10 years later?" and he said YES! With that said, he wouldn't put anything in writing for me.

He kept referring back that I was personally responsible for the loan. It's all mind boggling to me.

I would love to hear the thoughts the professionals here.

Ps. I am hopeful I can take out a 401k loan this year and stop making payments on it immediately with the hopes they default once I am dead. ;)

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RatherBeGolfing,

So are there different rules related to Loan Offset? If I quite my job at the end of July 2013, when should the loan be considered offset? According to Charles Schwab they could offset it whenever they feel.

Thoughts?

Thx

Brian

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Just thinking out loud here because we only have some pieces of information to go on.

IF the plan requires that a loan balance be paid off by your vested account balance upon termination, they would apply your non-loan assets to pay off your loan. Basically, if you owe $5,000 on your loan at termination, they apply $5,000 from your vested balance to pay the loan off. You are then issued a 1099-R for the $5,000 because it was "distributed" in order to satisfy your loan obligation. You don't get an actual check for the $5,000 because it was used to pay off the loan (and you already have the funds from the loan). This would be reported on the 1099-R as a code 1 if you are under 59 1/2, without the extra L that would be used for a loan default..

The "we can do it when we want" statements are odd though, I'm pretty sure you were talking to a call center.

 

 

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Sorry for so many messages. I just received the Summary Plan Description. It notes:

"Loan - You may borrow up to a maximum of $50,000 or 50% of your vested account balance, whichever is less. The minimum loan is $1,000, and you may have up to 2 outstanding loans at any one time. Loans must be repaid within 5 years, although residential loans have a maximum repayment term of 15 years. The annual interest rate is the Prime Rate at the time you take the loan plus 1%. You repay the loan bi-weekly through after-tax payroll deductions. If you leave the Company, you may continue to repay the loan. If you default on the loan, the remaining principal amount becomes taxable income, and you will receive a 1099 form to claim with your taxes."

Thoughts?

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Just thinking out loud here because we only have some pieces of information to go on.

IF the plan requires that a loan balance be paid off by your vested account balance upon termination, they would apply your non-loan assets to pay off your loan. Basically, if you owe $5,000 on your loan at termination, they apply $5,000 from your vested balance to pay the loan off. You are then issued a 1099-R for the $5,000 because it was "distributed" in order to satisfy your loan obligation. You don't get an actual check for the $5,000 because it was used to pay off the loan (and you already have the funds from the loan). This would be reported on the 1099-R as a code 1 if you are under 59 1/2, without the extra L that would be used for a loan default..

The "we can do it when we want" statements are odd though, I'm pretty sure you were talking to a call center.

In layman's terms: There is no "deemed" distribution when you have a distributable event (e.g. termination or age 59-1/2), The "deemed" part comes in when there is no right to a distribution, but the amount is being taxed as if there was.

Another piece of relevant info (which amounts to missed opportunity). A "deemed distribution" may not be rolled over, but an 'actual distribution' may be rolled over. As soon as your loan was offset in 2014, you had 60 days to write a check to an IRA of the amount in order to avoid taxation. This "may" have been reflected in your Special Tax Notice you would've received after you terminated employment.

Good Luck!

CPC, QPA, QKA, TGPC, ERPA

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Gannuscio, you can keep talking to the lackeys at the call center, or you can poke yourself in the eye with a sharp stick - same result. You'll probably get different answers every time you call. Heck, most people here are experts and we are disagreeing. (Although I have yet to see a credible answer as to why it should be deemed in 2014..."practical" is not credible, IMO.)

I don't have a better way to handle it, but be prepared to spend a lot of time on it. You need to move up the chain somehow to someone who understands a bit about the Code and Regulations, and give them the cite for Reg. Section 1.72(p)-1, Q&A-10(a), and ask them how they square their reporting with what the reg says. (Don't refer to the FAQs which support 2014 taxation.)

I guess the other option is to duke it out with the IRS and try to prove that the 1099 is wrong; that might actually be your best bet. I am chuckling when I think of Charles Schwab trying to correct a 1099 issued for 2014 and then issue one for 2013...never gonna happen. If something isn't right when it goes into their system, it's nearly impossible to fix.

Ed Snyder

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(I don't get the part about defaulting at the end of June and being treated as a distribution at the end of September. That doesn't make sense.)

The term default merely means that you failed to meet the terms of the loan agreement (and must now cure the failure by the end of the cure period). For instance, you may have a loan provision that require to remained employed. If you terminate, then that would be a default, You must now cure that default by paying the loan off. So, it goes to your definition of default. I've often heard people in our industry define "default" as an offset, but that's not the case. Default only means that you've began to operate outside the terms of your loan agreement (and must remedy in order to continue to maintain the loan).

Good Luck!

CPC, QPA, QKA, TGPC, ERPA

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The term default merely means that you failed to meet the terms of the loan agreement (and must now cure the failure by the end of the cure period). For instance, you may have a loan provision that require to remained employed. If you terminate, then that would be a default, You must now cure that default by paying the loan off. So, it goes to your definition of default. I've often heard people in our industry define "default" as an offset, but that's not the case. Default only means that you've began to operate outside the terms of your loan agreement (and must remedy in order to continue to maintain the loan).

Ah, thanks, now I see that the example in the FAQs is actually correct; I wasn't reading it carefully enough. However, the example in the regs remains on point, and I still do not see how a deemed distribution could/should occur AFTER the end of the cure period.

Ed Snyder

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I see your point. The Regs, when written, seemed to have made it a point to use a date within a calendar year for their example. It's never going to be an issue whether you offset a loan on October 5th (for example) instead of September 30th. When you're crossing tax years, then it issue becomes whether it is a hard-fast line in the sand for tax purposes. I don't think it would be egregious enough to warrant this level of scrutiny given a process that has been designed to meet the 72(t) standard. The issue comes into play, in my mind, when you look back and determine (in retrospect) that you would've faired better had the amounts been taxable in an earlier year than the one reported.

At the end of the day, the amount (at the time of offset), whether December 31st or early in January, could've avoided all taxation had it been rolled over to an IRA. Remember, at the point of offset, it's not a deemed distribution, but an actual distribution. I see you're point, but this is the absolute FIRST time I've ever heard of a situation where a participant is arguing for an earlier 1099R; when all could've been avoided by merely paying rolling over the loan (or requesting the loan offset distribution at the time the employment terminated). One thing that will always been constant in our industry, however, is that these types of issues will always exist at the lines where one period ends and another period begins. We recently had Regulations on post-severance Compensation because of deferrals made by employees who terminated late in the Calendar year.

It's always going to be an imperfect process. I'm not suggesting to undermine any rules (even though it may appear to be that way), but this is a one-off that could've been easily avoided.

Good Luck!

CPC, QPA, QKA, TGPC, ERPA

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I want to give a little more insight into why I take this position (FWIW). Earlier in my career, I actually left a daily provider to work for a Balanced Forward Provider (because balanced forward, at that time, seemed to provide the best opportunity to learn and apply all the rules). In a balanced forward environment, this would be a non-issue; the default would've happened on the December 31st valuation date. Applying many of these rules on a daily platform creates more of a challenge as everything is process prospectively while "compliance dates" or "as of dates" are used to illustrate the appropriate time-frame.

When it comes to actually offsetting a loan, you'd have to actually back-date the offset; which can be done but operates against the normal operation of a daily platform. If a December 31st payroll comes in on January 8th, you'd then see that payment wasn't made and go back and process a retroactive default to December 31st (changing the Year End Reporting and each day loan balance between January 1st and January 7th.

So, I agree with Bird on his argument that the Regulations are clear. I just see an potential issue on many daily platforms to administer this issue. A balanced forward platform could easily administer it because EVERYTHING is done on a accrual basis.

I just wanted to add that insight because many "newbies" (and I can say that :) ) have never experienced a balance forward platform.

Good Luck!

CPC, QPA, QKA, TGPC, ERPA

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Thanks for the clarification ETA Consulting. I took all paperwork to my CPA yesterday and we are going to protest the 1099 through the IRS and see where we end up. He wasn't confident either way and said it could depend on who's desk it ends up on. It's mind boggling to me that our tax code / regulations are so complicated.

I will follow up in a few months just to give everyone an update on the IRS response.

Thanks all for the information feedback as it was a helpful starting part to give my CPA information.

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