Pre-Tax Loan Repayments?

[TBob]

We have taken over administration of a 401(k) plan that allows for participant loans. The prior TPA told the plan sponsor, and a participant with an oustanding loan, that payments should come out of the participant paycheck on a Pre-tax basis. The plan sponsor had taken a number of payments out of the ee's paycheck on a pre-tax basis. Oops!

I am having a hard time convincing the participant that the payments should be after tax. I can't find a cite in the code/regs that specifically says "repayments should be made on a post-tax basis". I read through the loan regs and, although they talk about creating basis when you are repaying a loan after it has been deemed, the participant doesn't understand. He needs something clear and preferably official.

My latest response to him was "Have the prior TPA give you a cite that allows for loan repayments to be made pre-tax". I would like to provide something more concrete. Does anyone know how to win this argument before the participant, and possibly the plan sponsor, spend money on an attorney (not that I have anything against attorneys!) ? Any cites or articles???

[QDROphile]

Maybe someone can do better for you, but you may have to be satisfied with pointing out that no compensation is pre-tax unless the Internal Revenue Code has a provision that allows the amount to be excluded from income, such as section 125 and 401(k). You will find nothing in the Code that covers amounts used to pay plan loans.

The idea of using payroll deduction for plan loans is only a convenience. Payroll deduction is not a required source of money to pay the loan. You could have a payroll deduction to pay your mortgage. Who would argue that the deduction for the mortgage payment is pre-tax?

Don't feel bad about making the proponent of an idea provide the authority for it. That is the general rule in dealing with the IRS. If you can't show why you should get a deduction or exclusion, you don't get it. If you take the approach that you have to disprove incorrect notions, you will spend all day with silliness.

[Guest Pensions in Paradise]

Boy, if that were true, that would be a nice way to avoid taxes altogether. Lets say my salary is $50,000 a year. I borrow $50,000 from my retirement plan and then repay it with pre-tax payroll deductions. Voila, $50,000 annual salary tax-free.

[Guest b2kates]

the technical answer is that section 61 detetmines gross income; unless there is an exemption; such as 125, 401 and the medical exclusions.

I agree with QDROphile,

remember that release of debt is still taxable income. i.e. think of the deemed distribuitons rules for loans.

[Guest mrpoon]

So now that we have convinced the employer that they have a problem, what is the corrective procedure for loan payments with pre-tax dollars?

What if the problem goes back a number of years?

[Guest ddonohue]

I think the problem isn't yours, rather it belongs to the employee. Should the IRS find out about this method, the employee will be on the hook for the taxes he/she should have paid on those pre-tax loan payments. I would leave it up to him/her to go back and adjust the 1040's.

[Guest b2kates]

Can not tell from facts, May need to issue corrected w-2 based on prior reporting/lack of.