Plan distribution after deemed distribution of defaulted loan

[7806akp]

If a plan participant defaults on a loan which is treated as a deemed distribution and reported as such, what happens when the participant later takes an actual distribution of his account balance (assuming he never repaid his loan after it was deemed distributed)? For example, if a participant had a deemed distribution of $5,000 and upon actual distribution of his account balance the account consisted of $60,000 cash and the $5,000 loan receivable, does the participant receive the entire $60,000 cash or is the loan receivable offset so that the participant receives only $55,000 cash upon distribution? If the former is true and the participant is to receive $60,000 cash, why does anyone ever pay back a loan after a deemed distribution? If the latter is true, how is the amount taxed considering that the regs provide that the participant has no basis in his plan related to the $5,000 deemed distribution and appear to provide that the participant has $60,000 of gross income.

[Lou S.]

I'm a bit confused by your example.

If the participant has $60,000 in cash and $5,000 in outstanding loan his total balance is $65,000.

When you default the loan he still has $60,000 in cash but $0 in outstanding loan (for most practical purposes).

If he then takes the remaining balance he would get the $60,000.

Assuming it is the same taxable year he would get two 1099-Rs, one for the $60,000 (with whatever code applies) and one for $5,000 with code 1L or 7L as appropriate depending on age at default.

Does this help?

Of are you saying the participant only has $60,000 balance including the $5,000 loan in which case he would only have $55,000 in cash to start with?

[Guest Pete Joachim]

The employees' Plan account is equal to $65k ($5k outstanding loan balance + $60k). The $5k loan balance is defaulted and he is now required to include that $5k in his taxable income for that year (and if not age 59 1/2, subject to the 10% early w/d penalty). In essence, this is his penalty for failure to repay the loan - immediate taxation. No withholding is required since participant already has the $5k in his pocket.

When he requests distribution of his remaining Plan account, it is equal to $60k ($65 less $5k offset). If you only distributed the $55k, what would the Plan do with the other $5k?

If he elects to take the $60k as a cash distribution in the same taxable year as the deemed loan distribution, then the Plan is required to withhold 20% of $65k (rather than 20% of $60k). So he is taxed on a total of $65k (plus 10% penalty if applicable).

If he elects to take the $60k as a rollover, then there is no tax withholding since there is nothing to withhold from. He only includes the $5k deemed loan distribution in his taxable income for that year.

Hope this helps.

[Tom Poje]

even though a loan is defaulted and therefore deemed to be 'off the books', the loan is tracked on paper and continues to accrue interest. if the individual tries to take another loan, the outstanding 'loan' is counted against what the individual can borrow. That would be the reason for paying off the loan.

such deemed distributions should have been reported on the 5500 (e.g. line 2g [or 8e on the SF]), another reason for thinking of them being 'off the books', but again, as noted, you track them in case the person wants another loan.

[7806akp]

Thanks to all for your helpful answers. It is now clear to me.