Non-taxable loan

Looking for comments on this so-called "strategy".  Plan participant has an account balance of $200,000 which consists of $20,000 after-tax contributions and $180,000 of pre-tax contributions plus interest earned.  Participant requests a loan of $10,000 from the $20,000 after-tax portion.  Participant receives the $10,000 and begins to payback the loan via payroll deduction.  A month later, participant cancels the loan and plan administrator pays off the loan using the participant's pre-tax contributions. Two months later, the participant again requests a loan of $10,000 from after-tax funds, begins to payback loan, cancels loan, and plan administrator pays off the loan using pre-tax funds.  Ultimately, the participant was able to remove the $20,000 after-tax by itself.  1099-Rs will not be issued.   Any thoughts on this?

Several flaws in the 'process'.  Participant takes a loan and fails to repay it, then the loan will become taxable as if it were a distribution.  This will likely include a return of after-tax basis and earnings; and a Form 1099R will definitely be issued.

If your goal is to take a distribution of all the after-tax basis from the plan without receiving any of the pre-tax amounts, then this could likely be done with a distribution and rollover.  You'd need to provide details on the participants actual value in the plan.  What are the money types?  What money type contains the after-tax basis?  What are the withdrawal restrictions for that money type?

Good Luck!

I agree with ETA.  How do you cancel a loan without paying it back, refinancing, or a 1099R? 

I am just thinking out loud here and spotting issues.  I have not researched this.  But it seems to me that paying off a loan from after-tax funds with pre-tax contributions could be deemed a distribution of the pre-tax amounts and then a repayment by the participant.  Conceivably that could disqualify the plan if it does not permit in-service distributions, and could result in the additional 10% penalty if the participant is under 59 1/2.

I am not sure either of the answers given are addressing the heart of the question.  I am not sure the question is asked well.  (Back when I worked on 4k plans we never talked about a loan being cancelled vs defaulted/paid/distributed for example.) 

For the below I am assuming cancel means the person defaults on the loan as the payments have stopped and the person doesn't appear to be terminated. 

To me the answer hangs on the following issues and since I don't do loans any more I am not going to give an answer:

1)  Can you really say 100% of the loan is coming from JUST the after-tax source vs pro rata across the sources?  Back when I worked on 401(k)s it seemed like we always did pro rata but that could have been a system or firm decision as I don't recall this question being addressed.

2)  If you can take 100% of the loan from the after-tax source when a loan default happens can you really say 100% of the loan is basis vs a mix of basis and earnings?  Given my memories of the after-tax rules I don't think you can say basis comes out first but it has to be a mix of basis and earnings unless the after-tax money is very old after-tax money.  If it is a mix of basis and earnings than there is a taxable amount.

I guess I could be reading the original post wrong but to me those are the heart of the question and I don't see that being answered. 

I would add even if you could convince me only after-tax basis was involved in the loan default you would have to 1099-R the person it would simply show no taxable amount.  But there would always be a 1099-R. 

ESOP guy (and mctoe),

It is fairly common to restrict loans to certain sources and perhaps even allow the participant to select which source...for loan recordkeeping purposes.  Nevertheless, I think that if the loan were to default, it would be proper to treat it as a pro-rata taxable event from all sources, therefore, very little, presumably, would be from basis.  At least that's how I see it, and how I would prepare the 1099.

And there would be a 1099, as others have noted.  I suspect the driver of this idea is trying to get away with something without committing tax fraud, or otherwise gaming someone's system, with the incorrect thought that somehow these circumstances don't require a 1099-R. 

Believe it or not, this is recommended by the plan administrator as a way for the participant to receive the non-taxable funds only.  Yes, the plan is "canceling" the loan and will not issue any 1099-R's.   

Regulation 1.402A-1, Q&A-12, seems reasonably clear to me - the loan default would/should be treated as a pro-rata distribution from the Roth account as a separate account, and not combined with all plan assets to determine the taxable distribution. So while the total taxable distribution might be minimal, assuming there are ANY earnings in the Roth account, there would be some level of taxable distribution, albeit possibly a small amount. And it would of course be reportable.

1 hour ago, Belgarath said:

Regulation 1.402A-1, Q&A-12, seems reasonably clear to me - the loan default would/should be treated as a pro-rata distribution from the Roth account as a separate account, and not combined with all plan assets to determine the taxable distribution. So while the total taxable distribution might be minimal, assuming there are ANY earnings in the Roth account, there would be some level of taxable distribution, albeit possibly a small amount. And it would of course be reportable.

The OP just said after tax and not Roth, FWIW. Not sure it makes any difference.

3 hours ago, mctoe said:

Believe it or not, this is recommended by the plan administrator as a way for the participant to receive the non-taxable funds only.  Yes, the plan is "canceling" the loan and will not issue any 1099-R's.   

It would be a distribution, not a loan.
 

Quote

 

1.72(p)-1

Q-17: What are the income tax consequences if an amount is transferred from a qualified employer plan to a participant or beneficiary as a loan, but there is an express or tacit understanding that the loan will not be repaid?

A-17: If there is an express or tacit understanding that the loan will not be repaid or, for any reason, the transaction does not create a debtor-creditor relationship or is otherwise not a bona fide loan, then the amount transferred is treated as an actual distribution from the plan for purposes of the Internal Revenue Code, and is not treated as a loan or as a deemed distribution under section 72(p).

 

Is the participant eligible for an in-service distribution of deferrals?

The plan administrator is not going to make the second loan (and why bother?) so soon after a voluntary default.

Thank you Kevin C.  Clearly a distribution based on that Q & A.  Yes, the participant is eligible for in-service distributions.  

Bill, yes, good point. I assumed, and you know where that gets me...

Doesn't the first loan have to be paid back before a second loan can be taken anyway?

Or, does the fact that the participant has a distributable event (eligible for in-service w/d) result in the loan being offset, and thus it doesn't have to be paid back?

The "cancellation" of the loan is a deemed distribution.  If the participant is under age 59 1/2 the participant gets hit with the 10% additional tax (assuming no other exception).  The deemed distribution of ROTH money is not a qualified ROTH distribution, even if the participant meets the 5 year/59 1/2 rules.  Thus, any earnings used to fund the loan are taxed.  With a deemed distribution, unless the loan is afterwards repaid, the outstanding balance plus accrued interest reduces the maximum amount allowed under future loans.  I continue to believe there is a real possibility that the loan is a deemed distributed (and taxed) plus the use of the pre-tax 401(k) to repay the loan could be considered a taxable distribution (also potentially subject to the 10%), resulting in double taxation.  I'm not sure about double taxation though.   

19 hours ago, mctoe said:

Believe it or not, this is recommended by the plan administrator as a way for the participant to receive the non-taxable funds only.  Yes, the plan is "canceling" the loan and will not issue any 1099-R's.   

Please define plan administrator.  Employer?  Third party administrator?  I take some offense that this moron has wasted so much time.

4 hours ago, mctoe said:

Thank you Kevin C.  Clearly a distribution based on that Q & A.  Yes, the participant is eligible for in-service distributions.  

Any chance the after-tax basis is from pre-1987 contributions? If not, wouldn't it be easier to take an in-service distribution, roll over the pre-tax portion and receive the after-tax basis directly?  The pre-tax portion could be later rolled back into the plan, or, I suppose directly rolled back into the plan as part of the initial distribution.  There would be 1099-Rs, but no taxable amount for the distribution, since everything except the after-tax basis is being rolled over.

The rules seem to be different depending on whether it's non-Roth employee after-tax or Roth money. The Code, regs, and IRS are clear, I think, that you can't "source" a loan to non-Roth after-tax contributions. Requiring non-Roth after-tax to come out pro=rata across all participant accounts for any type of a distribution (including at least by implication a deemed distribution on loan default) was introduced into the Code in 1981 or 1986, or maybe 1996. I'd have to check. But this was a specific Code change made by Congress for some reason and IRS of course follows this.

When Congress enacted and subsequently amended the Roth deferral and in-Plan Roth rollover rules, they specifically said that all Roth contributions must be in a separate "Designated Roth Account" and did not include a rule that distributions from a plan containing both Roth and non-Roth have to be treated as pro-rata, but rather left the Code open to the interpretation that, unlike the situation with employee after-tax contributions, a participant could choose to have distributions come from (or to source all or part of a loan to) his/her Designated Roth Account, if the plan document or loan policy permits this. (Of course many don't address, and the recordkeeper in such a case will typically source distributions and loans pro-rata across the Roth and non-Roth accumulations, just like non-Roth employee after-tax.)

If, as the original question implies, the participant's basis was in non-Roth employee after-tax contributions, then I think the defaulted amount should probably be treated as consisting of after- and pre-tax amounts pro rata. On the other hand, if the loan was properly sourced under the plan document and loan form to the participant's Roth account, then you would follow Roth rules. If a distribution from the Roth account would not have been qualified, then a portion would be taxable, a portion would be recovery of basis, just like any other distribution from the participant's designated Roth account.

On 7/6/2018 at 10:03 AM, Bird said:

Please define plan administrator.  Employer?  Third party administrator?  I take some offense that this moron has wasted so much time.

Moron??  I was only trying to get some professional opinions regarding this questionable loan/distribution strategy recommended by a very large employer plan. 

15 hours ago, mctoe said:

Moron??  I was only trying to get some professional opinions regarding this questionable loan/distribution strategy recommended by a very large employer plan. 

Not you, the person who suggested it in the first place, which you are rightly questioning. 

I thought it was an interesting question. As with many questions, it requires some clarification.

6 hours ago, Bird said:

Not you, the person who suggested it in the first place, which you are rightly questioning. 

Ok, thank you!