Loan Default, 1099-R & Age 59 1/2

[TPApril]

Participant defaults loan on 3/31

Participant turns 59 1/2 on 7/1

1099-R is issued after end of the year

Early distribution penalty?

[Madison71]

So, the participant failed to make the agreed upon plan loan payments within the allowable cure period and on 3/31 this resulted in a loan default triggering a taxable deemed distribution on that date (or offset if separated from service)?   If so, then in my opinion the 10-percent additional tax on early distributions applies unless it meets another exception under 72(t) (separation of service after attainment of age 55, etc.).  The exception for age 59-1/2 are distributions which are made on or after the date on which the employee attains age 59-1/2.  If I understand correctly, the deemed distribution occurred on 3/31 which was over three months before turning 59-1/2.  The timing of the issuance of the Form 1099-R is not relevant. 

[TPApril]

thanks for confirming. in this case, plan sponsor told ee the loan was paid off and never restarted pmts after being told it was still outstanding. ee is still active so no distribution event.

complicating the situation - this was a year prior, but recordkeeper never formally defaulted the loan, so the 1099-R is being issued in current year, when ee is now over 59 1/2, instead of the year of loan default.

[Madison71]

Lots of issues going on here.  The plan sponsor is wrong in providing incorrect information to the participant that the loan was paid off and never restated payments.  The record keeper is also wrong in not treating the loan as a deemed distribution in the prior year once defaulted and not restated within the cure period.  A 1099-R cannot be issued in this case in the current year unless requested by the IRS under VCP.  I think this is one that should have been corrected under VCP either requesting re-amortization of the loan or request reporting in the current year.

[mctoe]

On 1/19/2018 at 3:51 PM, Madison71 said:

So, the participant failed to make the agreed upon plan loan payments within the allowable cure period and on 3/31 this resulted in a loan default triggering a taxable deemed distribution on that date (or offset if separated from service)?   If so, then in my opinion the 10-percent additional tax on early distributions applies unless it meets another exception under 72(t) (separation of service after attainment of age 55, etc.).  The exception for age 59-1/2 are distributions which are made on or after the date on which the employee attains age 59-1/2.  If I understand correctly, the deemed distribution occurred on 3/31 which was over three months before turning 59-1/2.  The timing of the issuance of the Form 1099-R is not relevant. 

I believe the age 55 rule exception does not apply regarding loan defaults. 

[Madison71]

I believe on a loan offset that the age 55 rule could apply upon separation from service if no default while actively employed (which I know this is not the case since the individual is still actively employed).  At the time of the original post, I was unsure whether the default occurred because of failure to repay while actively employed or after separation from service.  

[Tom Poje]

from the ABA Q and A 2015 #2

(Ha, I wasn't even looking for this, but was looking for something else totally unrelated. not even sure why I looked at this either, but those things happen)

 

2. § 72(p) – Plan Loans

A participant who took out a loan from a Section 401(k) plan fails to make timely payment of the loan (after the cure period). As a result, a deemed distribution occurs in April due to a loan default and later in the same calendar year in November a loan offset occurs because the defaulted participant later reached  age 59½ in November which is a distribution event under the plan. At the time the participant defaulted on the loan, no exception to the Code Section 72(t) early distribution penalty was available to him. Does the plan administrator who issues Form 1099-R still indicate that the distribution was a deemed distribution (Code L in box 7 of Form 1099-R) and an early distribution (Code 1) even if there is a loan offset and the participant is over 59½ by the time the plan administrator issues the Form 1099-R?

Proposed Response: Yes. Once the participant defaults on the loan, the loan is considered a deemed distribution regardless of whether a loan offset occurs later in the same calendar year.

IRS Response: The Service representative agrees with the proposed response. The Service representative stated that it does not matter that the Form 1099-R has not yet been issued at the time the individual turns 59½ as the general rules would apply.

[Madison71]

Tom - that is about as on point as you can get.  Thank you for weighing-in.

[Tom Poje]

sometimes you simply get real lucky.

I really only opened up the one file I had to simply verify that was the last year the ABA had a Q and A, and since that was a question on the first page it caught my eye, and I thought, odd, someone just asked about that on Benefits Link. if it had been on a later page I wouldn't have looked.

[TPApril]

I concur with Madison71 in thanking Tom for such an apropos find.

Concluded - in this case there is indeed an early w/drawal penalty

To be determined - getting the 1099-R issued for the earlier yr.

[Liz S]

Can an employee default on a loan repayment while still actively employed?  I understand an administrative oversight is what this post is actually about, but when I first read it, it appeared as if the employee failed to make the required payments. That can only happen if the employee asked for the payroll deductions to cease. Or am I missing something?

[RatherBeGolfing]

27 minutes ago, Liz S said:

Can an employee default on a loan repayment while still actively employed?  I understand an administrative oversight is what this post is actually about, but when I first read it, it appeared as if the employee failed to make the required payments. That can only happen if the employee asked for the payroll deductions to cease. Or am I missing something?

The loan defaults when payments are not made.  That could happen because the employee requested payroll deductions to cease or because the employer failed to make loan payments (or even failed to withhold loan payments).  Employer error happens all the time but the loan is still defaulted.

[Martine Benne]

Here is a similar question (sorry to zombie this thread): Instead of the 59-1/2 (59 6 months exactly) happening after the cure, what if it is during the cure followed by a subsequent default? For an example, 01 Feb take out a 401K loan. 14 Feb is terminated/quits, Happy Valentines Day. 60 day cure period ends on 15 April, comes and goes, and she allows the loan to default. Pretty cut and dried.

Here's the twist: she turns 59 1/2 on 07 April, a week before the end of the cure period.

I just want to clarify when the actual default occurs for purposes of distribution. The way I read it, the default and thus the distribution deemed are at the end of the 60 days cure period, 16 April.  She would seem to have avoided the early withdrawal penalty (if any, see below), and it is simply a normal distribution event since the event was after her "half birthday". Normal taxes and a 1099-R (But no need for a 5329). 

Or is this to deemed to occur on the termination date 14 Feb due to no effort during the cure, and instead the Rule of 55 applies. Or is there a penalty applicable at all that I somehow don't know about due to the loan?

Edge cases like this make me nervous, and the loan throws all kinds of smoke.

(by Rule of 55 I mean IRS Pub 575 "Additional exceptions for qualified retirement plans.")

The reason I'm asking is I may see a relative in a similar scenario if what happens is what I think will happen. Trying to talk her out of taking out a loan she doesn't (yet) need, and use "Rule of 55" and just take what she needs as a distribution when she needs it, and ride it out that way if necessary (instead of a big chunk of a loan).