2024 1099-R Accuracy for Participant with Loan Default vs. Offset

[Jay S]

A plan participant terminated employment in June 2024 with an outstanding loan. The plan permits immediate distributions upon termination.

• The participant received a distribution in June 2024.
• The loan was not offset against with the distribution and subsequently defaulted between September 30th and October 1st, 2024. This appears to comply with the "2-quarter rule" for loan repayment requirements & default.
• As the participant was not rehired, the loan accrued interest from the distribution date until the default date.

Issue:

The participant's 2024 1099-R includes interest accrued on the defaulted loan, even though the loan was not offset against the distribution in June.

Questions:

1. 1099-R Accuracy: Should the participant request a correction to their 2024 1099-R before filing their taxes? Is the 1099-R likely to overstate the taxable distribution due to the inclusion of interest accrued between the distribution date and default date?

2. Plan Policy and Procedures:

   • Are there any specific laws or regulations that address this situation?
   • Does the plan document or loan procedures outline the treatment of outstanding loans upon termination and distribution?
   • Is it reasonable to expect the plan sponsor to actively seek information about the participant's loan repayment intentions at the time of distribution to avoid potential interest accrual?
   • Given the plan's offset provision, why wasn't the loan offset at the time of the distribution?

[EPCRSGuru]

What does the Plan document (or the Loan Policy) say?  Does the Plan even allow for loan repayments to be made after termination of employment?  I think most plans nowadays say that repayments are only made through payroll deduction and a loan is due and payable upon  distribution of the participant's benefit.  

[Jay S]

In this case the Loan Agreement states:

• "If the borrower terminates employment this is not automatically considered a loan default under the plan" 

 

• "If a distribution triggering event occurs (e.g. Termination of Employment) combined with failure to repay the loan within the cure period, the loan admin. has right to foreclose on the vested account balance that was previously pledged."

As my original post, it doesn't really explicitly outline what occurs when a distribution is taken and I thought the rule was it needed to be Offset if not repaid at that point (within the cure period). I didn't think they were permitted to continue to collect interest on the balance until the end of the cure period, post-termination distribution.

 

Do I assume they maintain the right within the cure period to keep the loan or not? In this case it seems like they just defaulted to the recordkeeper cure period and let it sit and collect interest as opposed to working in the participants best interest and considering if they even had the intent to repay it...something just seems so off about it.

[Bri]

The problem is that if he asked for a full distribution, that should include the loan as of that date, not when it would have gone into default, like if he'd only asked for a partial withdrawal of his vested benefit.

 

[Paul I]

Given the circumstances, it seems that the plan administrator and/or recordkeeper have conflated the rules for treating deemed distributions and for treating loan offsets.  Either way, the interest should not have been reported on a Form 1099R (see the Instructions for Forms 1099-R and 5498 (2024) page 9). 

[Note that the instructions also address topics related to reporting deemed distributions and loan offsets on a Form 1099R that you may find interesting.]

Many plans require loans to be repaid solely through payroll deductions, so a terminated employee cannot continue to make loan repayments even if they wanted to.  Some plans do allow terminated employees to continue making payments, and the participant should be informed of the process on how to continue making loan repayments and also how to inform the plan/recordkeeper not to default the loan.

Part of the issue may be incomplete disclosure about how the plan will treat loans in the event a participant terminates employment.  IMHO, leaving the loan for a terminated participant on the books and simply waiting for the loan to default is probably the worst way to administer the loan.