At first blush, taking out a plan loan can sound like easy, tax-free money.
But borrowing against a company 401(k) is anything but. The rules are tricky and violations can trigger costly taxes and penalties — exactly at a time when the employee’s funds are least likely to be available. This is precisely where financial advisors can step in and provide a valuable service to clients. By understanding the plan loan rules, they will be equipped to counsel their clients on whether a taking a plan loan is a good or bad idea, given their unique personal situation.
The advantages of such loans are initially seductive. In addition to providing early access to a portion of retirement accounts, they also:
- Are generally easier to obtain than other bank financing (poor credit does not factor into approval process).
- Are initially tax- and penalty-free, and continue to be so, if all the conditions are met.
- Have lower interest rates than loans available elsewhere.
- Require repayments back to the individual’s account — not a bank.
- Allow for optional loan provisions that can always be adopted — even to most pre-approved plans.
To qualify for this preferential tax treatment, the following conditions must be met: the plan document must permit loans; loans are limited to the maximum amount; the repayment period must fall within the statutory period; repayments must be continuously made on at least a quarterly basis; and interest will be assessed on repayments.
Your clients should be aware that plans loans allow participants early access to only a portion of their retirement accounts. That’s because the tax code limits plan loans to the lesser of 50% of the vested account, or $50,000.
There is one exception to this rule: If 50% of the vested account balance is less than $10,000, the participant can borrow up to $10,000 (not to exceed the vested account). However, this exception is optional, and plans can choose to ignore this.
Playing by the Rules
Now, the potential pitfalls.
Tax problems come into play when the above rules are not followed precisely. The recent case of Gerard J. McEnroe and Regina McEnroe v. Commissioner of Internal Revenue is a potent reminder of how tax consequences occur when a deemed distribution occurs.
Gerard McEnroe participated in the New York City Employees Retirement System, a 401(a) tax-qualified plan, as an employee of the New York City School Construction Authority.
McEnroe was age 51 in 2015. In July 2014, he borrowed $26,045 from his NYCERS account to pay a child’s college tuition expenses. McEnroe immediately began repaying the loan, having amounts deducted from his biweekly paycheck. In May 2015, McEnroe left his job with the School Construction Authority and stopped making loan repayments. After a short stint with another employer, he returned to SCA in September 2015. After learning that NYCERS would be treating his outstanding loan balance as a taxable distribution, he contacted the SCA HR office.
In November 2015, an HR representative wrote to NYCERS saying that McEnroe wanted to have his loan “reinstated” so that the outstanding balance would not be considered a distribution and to resume payroll deductions immediately. His loan repayments through payroll deduction resumed in early December 2015.
The Form 1099-R reported a 2015 taxable distribution of $22,284 — the outstanding balance on McEnroe’s loan as of June 24, 2015. The McEnroes did not include the $22,284 as taxable income on their 2015 federal tax return and also did not file Form 5329, or otherwise treat the deemed distribution as an early distribution.
In response, the IRS issued a notice of deficiency of $9,638 for the 2015 return, attributable to the deemed distribution and a 10% additional early withdrawal penalty tax. The IRS also assessed a 20% accuracy-related penalty of $1,928.
The McEnroes appealed to the Tax Court, arguing that it was inequitable to impose income tax and the 10% early withdrawal penalty because NYCERS had not provided McEnroe timely notice of his loan default and, further, that he had acted reasonably and in good faith by “reinstating” the loan and resuming repayments.
The Tax Court ruled against the McEnroes on both the income tax and 10% penalty. (Although in a footnote the court said the IRS had conceded that the McEnroes did not owe the $1,928 accuracy-related penalty.) On the deemed distribution issue, the court noted that the tax code provides that a loan made from a tax-qualified plan is considered a taxable “deemed” distribution to the recipient unless the loan meets certain requirements.
The court cited IRS regulations providing that the failure to make any installment payment when due, under the terms of the loan, violates the level amortization/repayment requirement and results in a deemed distribution. The regulations let the plan administrator allow for a cure period for late installment payments, but that period cannot extend beyond the last day of the calendar quarter following the calendar quarter in which the payment was due.
The court pointed out that even if NYCERS had a cure period, McEnroe did not resume loan repayments until after the cure period was required to end. He also did not cure the defect. Therefore, according to the court, NYCERS correctly concluded that McEnroe had a deemed distribution of $22,284 that was taxable income for 2015.
On the 10% early withdrawal penalty issue, the court noted that it has consistently ruled that the tax code does not provide a hardship exception to the penalty.
Based on the disclosed facts, this appears to be a harsh result. While McEnroe’s loan was technically in default, the only reason he missed repayments was because he had temporarily left SCA employment and was apparently was not given the opportunity to continue those repayments (by sending checks to the plan) after left.
There is also no indication that he could pay off the loan in full after he left, since he didn’t return to SCA until sometime in Sept. 2015 and it was likely administratively impossible for repayments to have resumed by Sept. 30. Finally, the court did not give any consideration to the fact that McEnroe took the initiative to resume repayments by contacting the SCA HR office or that NYCERS apparently led him to believe that it would reverse its treatment of the loan as a deemed distribution.
Billups and Marquez were New York City employees with plan accounts in NYCERS. They both also had outstanding loans from the plan that were up to date when they walked into their human resources office in 2005.
NYCERS allowed employees to not only take multiple loans, but also to refinance existing loans. The men each selected the refinancing option, even though both were warned that this might cause all, or a portion of their loan, to become immediately taxable. Both men were urged to contact NYCERS before submitting the paperwork. From the court records, it appears neither did.
The refinancing caused both men to exceed the maximum loan limits. As a result, the plan issued the employees an IRS Form 1099-R for 2005, reporting the excess over the limit as a taxable distribution. Billups had taken multiple large loans and the refinancing caused him to exceed his maximum loan limit by $39,748. Marquez only had one outstanding loan for a much smaller amount, but he exceeded his loan limit by $10,032.
On the advice of his accountant, Billups reported the deemed distribution, but also tried to report the amount as a rollover. Marquez simply ignored the 1099-R and neglected to include the income on his 2005 tax return. Neither man paid the 10% early distribution penalty although both were under age 59 ½ and no other exception applied.
In these cases as well, the IRS deficiencies were upheld, and both men were ordered to pay income tax and early distribution penalties on the deemed distributions.
Armed with a 360-degree view of plan loans, advisors can now share three crucial bullet points with any client considering them.
Plan loans should be a last resort. An outstanding plan loan can have serious tax consequences if a participant leaves employment — whether voluntarily or not. For this reason, clients in financial need should be advised to pursue hardship withdrawals (if available) or sources of funds outside the plan before taking a plan loan. (Previously, participants were required to take a plan loan before withdrawing 401(k) funds for a financial hardship, but that requirement has now been relaxed.)
Always check official plan communications. Make sure clients do not rely on a written statement or inference by an HR or plan representative. Such incorrect statement — incorrect as it may prove to be — will not hold up in court in the face of statements made in an official plan communication, such as a summary plan description. Had McEnroe consulted the NYCERS written communications, he might have discovered that he had options to avoid a default — ones that were not orally communicated to him.
Know the difference between deemed distribution and distribution of offset amount. A deemed distribution (such as occurred in these cases) should be distinguished from a distribution of a loan offset amount. The former occurs when one of the tax code loan requirements is violated. The latter occurs when a participant’s account balance is offset by the outstanding loan balance in order to repay the loan. The plan loan offset normally occurs when a terminating employee requests a distribution of his account balance. A loan offset amount can be rolled over to an IRA or another employer plan by April 15 of the year following the year the offset occurs (or Oct. 15 if an extension is filed.) A deemed distribution is taxable and cannot be rolled over. That’s a critical distinction.