Taxes on interest of 401k loan

[Guest mcdanieldon]

I took out a 401k Profit Sharing Plan loan 5 years ago with my company for $10,000. I terminated my employment soon after and I was unable to payback the money for the loan. I couldn't get the rest of my money from the plan because their contract states that they can hold the money for 5 years after you terminate employment. All my statements up to this point stated my loan balance as $9,969.63. So what they did this year was charge me 5 years interest at 9.5 on the loan money and sent me a 1099-r that has a gross distribution of $13,921 on it for the loan. And another 1099-r that has the balance of the account $68,971.00 that I rolled into another 401k. This doesn't seem right. Why should I pay taxes on interest money I didn't receive. Can anyone explain this to me please.

[QDROphile]

It seems that the loan should have been treated as taxable much earlier, probably more like six months after you failed to make a scheduled payment. Once the loan was treated as distributed (or actually distributed by offset), the interest after that point would not be taxable. Accrued interest up to that point would be included in the distribution and would be taxable. It sounds like your Form 1099 for the loan was years late and about 4 years of interest too much.

You need to check the defaullt and distribution rules for the plan, possibly explained in the summary plan description. The plan administrator should also be questioned. The five year distribution delay in the plan design should not trump the rule on when defaulted loan amounts are taxable and misunderstanding about that is probably what caused the problem.

[Lame Duck]

There was an excellent article on deemed distributions and the reporting of interest for tax purposes that appeared in Benefitslink on February 5, 2004. I'm sorry I don't have a link to it but someoen else might.

[E as in ERISA]

It sounds to me like this was a loan offset (actual distribution), not deemed distribution. They simply treated the loan balance as a taxable distribution at the time that an actual distribution first became available. There was no obligation to "default" and 1099 the loan at an earlier date, as the final loan regs need not be strictly applied to a loan taken out five years ago. A plan could apply a reasonable interpretation of the rules prior to that. I would guess that most plans did not use this method. But that doesn't mean its unreasonable.