Payback Loan After Default - after 1099R issued

Employee stopped working for the company, therefore defaulted on the loan took out for primary home purchase. Loan is considered 'Deemed Distribution', 1099R is issued, and time has passed over a year. Employee called saying tax for the previous year has not yet been filed, although 1099R has been received. Can employee still pay back the loan, and not utilize the 1099R while filing for tax for the previous year? Thanks in advance! 

1 hour ago, Sophia Wang said:

Employee stopped working for the company, therefore defaulted on the loan took out for primary home purchase. Loan is considered 'Deemed Distribution', 1099R is issued, and time has passed over a year. Employee called saying tax for the previous year has not yet been filed, although 1099R has been received. Can employee still pay back the loan, and not utilize the 1099R while filing for tax for the previous year? Thanks in advance! 

Too late; he has a distribution which is a fact under the plan rules.  

If it was a ‘loan offset’ then the employee would have extra time to do a rollover of the loan offset amount. However, since you said it is a ‘deemed distribution’ it is not eligible to be rolled over.

And the answer might be different in 2020 if it is COVID-19 related, but that's not really your question here.

This is not 2020, not COVID-19 related. But I have read somewhere on this forum that the loan can be repaid back, but I am not quite sure what the tax implication is, especially if they haven't paid the tax for that distribution yet. 

3 hours ago, Sully said:

If it was a ‘loan offset’ then the employee would have extra time to do a rollover of the loan offset amount. However, since you said it is a ‘deemed distribution’ it is not eligible to be rolled over.

Indeed.

The 1099 indicates the tax liability due.  Repaying the loan afterwards creates basis, though, so they won't owe taxes again on the amount when it's later distributed out of the plan in some future year.

21 minutes ago, Bri said:

The 1099 indicates the tax liability due.  Repaying the loan afterwards creates basis, though, so they won't owe taxes again on the amount when it's later distributed out of the plan in some future year.

Can you explain that a bit more? so the tax for the year 1099R was issued still needs to be paid as distribution, is there any penalty to be paid on that? If the loan amount is repaid, creates basis has any relationship with pre-tax money, post-tax money? Sorry I am super confused what would the payback do.

21 minutes ago, Sophia Wang said:

Can you explain that a bit more? so the tax for the year 1099R was issued still needs to be paid as distribution, is there any penalty to be paid on that? If the loan amount is repaid, creates basis has any relationship with pre-tax money, post-tax money? Sorry I am super confused what would the payback do.

With a deemed distribution, the participant is taxed as if he received a distribution, but he still owes the plan the borrowed proceeds because the transaction was a loan, not an actual distribution.

There is no withholding (which is obvious since this was initially a loan, not a distribution).

A deemed distribution under §72(p) is reported on Form 1099-R, as if the plan actually made a distribution. The distribution is coded in Box 7 as either a regular distribution, or a distribution that is a premature distribution, depending on whether the participant is under age 59½.. The 1997 Form 1099-R introduced code “L” which is also included in Box 7 to identify the distribution as a deemed distribution under §72(p).

The distribution is reported to the IRS like other distributions, and any later offset of the defaulted loan (including accrued interest) is not reported again at the time of the offset.

When the offset later occurs, the account balance will be reduced at that time by treating the offset as an actual distribution. When the plan deems the loan to be a taxable distribution under §72(p), the deemed distribution itself does not trigger basis in the participant's account. It is only when repayments are made on the previously-taxed loan that basis is generated. This coordinates with the reporting rules when the loan receivable is offset, because the unpaid loan balance that was deemed distributed is not reported again at the time of the offset.

Since the deemed distribution treatment under §72(p) is solely a tax rule, and is not treated as an actual distribution for other purposes, the deemed distribution does not affect the participant's continued obligation to repay the loan. The loan obligation is not extinguished until the loan is repaid, either by the participant through a resumption of loan payments, or by offset against the participant's accrued benefit.

Here is an example of how this works: In 2013, Rita receives a participant loan in the amount of $15,000. Before the loan is fully repaid, Rita defaulted on the loan, resulting in a deemed distribution under §72(p) of $3,000. Rita resumes payments on the loan sometime after the deemed distribution. Her payments following the deemed distribution totalled $3,800, which includes the $3,000 default amount plus interest included in her remaining loan payments. Rita has $3,800 of basis in the plan attributable to her repayment of the previously-taxed portion of the loan. On February 1, 2019, Rita terminates employment and is paid a lump sum distribution of her vested account balance. The amount distributed is $90,000. The taxable portion of Rita's distribution is $86,200, because the basis of $3,800 generated from the repayments on the previously-taxed loan is not includible in gross income under the basis recovery rules. Also note that since the taxable amount of $86,200 is part of an eligible rollover distribution, it is subject to the 20% withholding rules to the extent it is not directly rolled over.

I repeat. The original post talked about a deemed distribution. But it also mentioned that there was a termination of employment. That means the o p probably got it wrong. And everybody who is contributed to this thread talking about a deemed distribution is contributing to this nonsense. 

The 1099-R itself will have the answer.

If the code is 1M or 7M then it is a "qualified plan loan offset" and it can be rolled over by paying the amount of the offset to an IRA before the individual's tax filing deadline (presumably 7/15). Generally this is what occurs when defaulting on a loan in conjunction with a termination of employment.

If the code is 1L then it is a deemed distribution which is not eligible for rollover.

If it is code 1 or 7 then it is a loan offset which can be rolled over subject to the usual 60-day deadline. In other words it's too late now.

1 hour ago, Mike Preston said:

I repeat. The original post talked about a deemed distribution. But it also mentioned that there was a termination of employment. That means the o p probably got it wrong. And everybody who is contributed to this thread talking about a deemed distribution is contributing to this nonsense. 

Right. A deemed distribution (employee defaults, but there is no independent distributable event, so he/she gets a "dry" 1099-R, so to speak, showing only the amount of "air" distributed) can be paid back, because the loan obligation still exists as a commercial transaction between participant and plan's trust, even though IRS says it's time to pay tax. Repaid amounts create basis, and in essence are like after-tax contributions, but not subject to limits or 415(c). "Loan offset" distributions are actual distributions, ending the repayment obligation to the plan, and cannot be paid back, although as Sully above stated there is an extended rollover deadline under, what, TCJA I think. There has been so much legislation recently it's hard to keep track.

11 minutes ago, C. B. Zeller said:

The 1099-R itself will have the answer.

If the code is 1M or 7M then it is a "qualified plan loan offset" and it can be rolled over by paying the amount of the offset to an IRA before the individual's tax filing deadline (presumably 7/15). Generally this is what occurs when defaulting on a loan in conjunction with a termination of employment.

If the code is 1L then it is a deemed distribution which is not eligible for rollover.

If it is code 1 or 7 then it is a loan offset which can be rolled over subject to the usual 60-day deadline. In other words it's too late now.

What would cause a 1 or 7 in this circumstance in lieu of 1M or 7M?

4 minutes ago, Mike Preston said:

What would cause a 1 or 7 in this circumstance in lieu of 1M or 7M?

If there was actually a termination of employment, probably nothing - but who knows if there are other facts we are missing. Maybe the participant took an in-service withdrawal prior to termination? Figured it couldn't hurt to throw it out there.

There was no hard 'termination of employment'. This employee was a consultant that was paid on hourly basis, and after a previous project, he stopped taking on additional project, but no official termination of employment with the company, and I think the HR didn't terminate in the 401k system as well. But it has been over a year by now. 

Thank you all for your explanation. This was something I don't understand at all. 

29 minutes ago, Sophia Wang said:

There was no hard 'termination of employment'. This employee was a consultant that was paid on hourly basis, and after a previous project, he stopped taking on additional project, but no official termination of employment with the company, and I think the HR didn't terminate in the 401k system as well. But it has been over a year by now. 

Thank you all for your explanation. This was something I don't understand at all. 

There is no such thing as a "hard" termination.  He either ceased employment when he stopped having work and getting paid, or he continued being an employee and was paid or was on a leave of absence.  I vote for him being terminated. Someone who works like that and comes in and out is actually routinely being terminated and then rehired.  The termination is a matter of fact; was he terminated or not. There is no necessity for an "official" termination, whatever that is. The fact that HR screwed up is just normal for most HR folks.

If I may ask one more time just to be clear 100%. At this point, he would have to file tax considering 1099-R amount is regular distribution, the box 7 says '1L', he is in late 30's. Is there penalty involved as well? 

Since he still have the option to pay the loan back with interest, the benefit of that payback is to increase his 401k basis, but that amount he puts back is none-taxable in the future, but the growth of the funds will be taxable in the future when withdraw occurs. 

Thank you all again for educating me! 

The 1 part of the 1099-r code indicates no known exception to the penalty for an early withdrawal exists.

On 5/27/2020 at 5:51 AM, Sophia Wang said:

-Employee stopped working for the company, therefore defaulted on the loan took out for primary home purchase. Loan is considered 'Deemed Distribution', 1099R is issued, and time has passed over a year. Employee called saying tax for the previous year has not yet been filed, although 1099R has been received. Can employee still pay back the loan, and not utilize the 1099R while filing for tax for the previous year? Thanks in advance! 

Now that you have clarified, it looks like your best bet is to go back to whoever issued the 1099R with 1L as the code and try to convince them it should have been 1M due to the fact that he was terminated. It should be a simple matter to issue an amended 1099-R once you convince them the existing 1099R is wrong.  The tricky part will be convincing them it is wrong.

2 hours ago, Mike Preston said:

Now that you have clarified, it looks like your best bet is to go back to whoever issued the 1099R with 1L as the code and try to convince them it should have been 1M due to the fact that he was terminated. It should be a simple matter to issue an amended 1099-R once you convince them the existing 1099R is wrong.  The tricky part will be convincing them it is wrong.

What would the 1M do differently than 1L? 

1 hour ago, Sophia Wang said:

What would the 1M do differently than 1L? 

1M is a Loan Offset due to termination of employment or termination of the Plan. The participant has until the extended due date of  their tax return for the year of the distribution to "pay back" the loan as a rollover rather than the usual 60 days and thus avoid current taxation.

1L is a Loan Default not eligible for rollover.

11 minutes ago, Lou S. said:

1M is a Loan Offset due to termination of employment or termination of the Plan. The participant has until the extended due date of  their tax return for the year of the distribution to "pay back" the loan as a rollover rather than the usual 60 days and thus avoid current taxation.

1L is a Loan Default not eligible for rollover.

We didn't find out about this since he extended his tax filing, and then missed the extension. So we are way overdue on the tax. Would this still be ok to 'pay back' the loan? Or we will have to incur taxation, and then if they want to pay back, it will only just increase his 401k basis? Also, does this taxation incur penalty? 

If it was distributed in 2019 and the offset code is 1M he has until 10/15/2020 to come up with the funds and deposit as a rollover. If he's filed his 2019 taxes, he can file an amended return. At least that's my understanding.

1 hour ago, Lou S. said:

If it was distributed in 2019 and the offset code is 1M he has until 10/15/2020 to come up with the funds and deposit as a rollover. If he's filed his 2019 taxes, he can file an amended return. At least that's my understanding.

This has been a few years...... (sweat)

10 hours ago, Sophia Wang said:

This has been a few years...... (sweat)

There is no way to fix this.  He owes the tax, plus 10% penalty if he was under 59 1/2 (plus late payment penalties if applicable).  The only scenario for avoiding the tax and penalty would be for a 2019* distribution (loan offset) where he comes up with money outside of the plan and rolls it to an IRA before the filing deadline.  Very few, if any, people repay the loan back to the plan (intentionally), because it doesn't accomplish much.

*Which I think was a natural assumption of previous posters.

Sophia,

I just now came across your post(s).

You are correct.  As per the TCJA Section 13613, there is a provision for Qualified Plan Loan Offsets.

Qualified Plan Loan Offset Amounts Section 13613 of TCJA amended section 402(c)(3) of the Code to provide an extended rollover deadline for qualified plan loan offset (QPLO) amounts (as defined in section 402(c)(3)(C)(ii)).3 Any portion of a QPLO amount (up to the entire QPLO amount) may be rolled over into an eligible retirement plan by the individual’s tax filing due date (including extensions) for the taxable year in which the offset occurs. A QPLO amount is defined in section 402(c)(3)(C)(ii) as a plan loan offset amount that is treated as distributed from a qualified employer plan to an employee or beneficiary solely by reason of: (1) The termination of the qualified employer plan, or (2) The failure to meet the repayment terms of the loan from such plan because of the severance from employment of the employee.

 https://www.irs.gov/pub/irs-irbs/irb20-37.pdf