Deemed Distribution vs. Loan Offset Amount

[Guest cease]

Please pardon me as I continue to struggle with the following:

In the case of a 32 year old participant that takes a loan from his/her self directed account within a 401(k) plan where the loan consists of EE and ER money. The participant continues to be activel employed and stops making payment on the 5 year loan after 1 year. The one-year period is on March 31, 2002. The plan adminstrator applies the cure period and repayments still do not occur. As of the 12/31/02, the loan is in default.

I have reviewed Q&A under the regs of 1.72(p)-1, paying close attention to Q12. I am convinced that the loan cannot be treated as a plan offset amount (because of the in-service distrubution restrictions on EE contributions). Can the loan be treated as a deemed distribution? It appears that A12 is indicating that while an in-service distribution cannot take place (I am assuming for purposes of eligible rollover treatment), it is still considered a deemed distribution. If it is considered a deemed distribution, is it subject to tax reporting on a 1099-R in 2002 year?

Is it possible to have a deemed distribution where tax reporting is not required?

Thank you for taking the time to review this question and for your patience in helping me get through this issue.

[E as in ERISA]

I generally agree that an offset cannot be made and the default is of the type that would generally result in a deemed distribution under the 72(p) regulations and this would cause a 1099 to be issued. However, you might want to check the applicable date of those regulations. I think that you are only required to apply them to plan loans that issued after January 1, 2002.

[AndrewZ]

Without doublechecking myself, this is what I understand the rules to be in that situation.

1. The loan is deemed to be in default based on deadlines set forth by the plan's Loan Policy or the determination of the Trustee. The IRS sets a maximum time limit of the end of the quarter following the quarter in which the first missed payment was due. In your example, it appears the default date is June 30, 2002?

2. The defaulted loan becomes taxable to the participant via a 1099-R with code "L" or "L1." It is not eligible for rollover, as indicated by the code "L." If the account balance cannot be offset due to restrictions on 401(k) distributions or if the participant is not eligible for any inservice distributions allowed by the plan document, then it must continue to be carried in the participant's account, but would create an after-tax basis and be reported as non-taxable on the 1099-R when distributed.

3. The Trustee is still required to attempt to collect payments. Any payments made would create an after-tax "basis" in the receiving accounts, which must be tracked for 1099-R purposes when the account is later distributed.

Hope this helps.

[Guest cease]

Thank you both for your input. I really appreciate this.