Borrowing From Your 401(k)?

A recent court case demonstrates the need to pay very close attention to the procedures for a repayment of a 401(k) loan, and that there is no “reasonable cause” exception when a taxpayer fails to make a 401(k) loan repayment. 

In Frias, T. C. Memo. 2017 – 139, July 11, 2017, an employee left for maternity leave on July 30, 2012, to have her third child. Here are the facts of the case: 

  • On July 27, 2012, she entered into a loan agreement with her 401(k) plan administrator for a $40,000 loan.

  • The loan repayment agreement required bi-weekly payroll deductions to start on the first paycheck issued after August 10, 2012.

  • The loan agreement included procedures and deadlines for fixing any delay in repayment (including the “cure” period), and when the loan would be considered to be in default.

  • Upon a default, the unpaid balance plus accrued interest is considered to be a deemed distribution. 

While the employee was on maternity leave, she received biweekly paychecks. Upon returning to work on October 12, 2012, she learned that the loan payments were not withheld. She immediately made a $1000 payment to the 401(k) plan administrator on November 20, 2012, and then instructed her employer to withhold and remit increased loan payments through July 2013. The taxpayer continued to make payments of the original loan until the loan was repaid in full on July 9, 2014. Note that this is less than two years after the initial loan was made. 

The 401(k) plan administrator issued a Form 1099-R to the taxpayer for 2012 showing a taxable distribution of $40,065. The Form 1099-R was available online, and although the employee had access to the website, she did not access or review the Form 1099-R. She did not report the distribution on her 2012 federal income tax return. The IRS assessed tax plus a penalty on the deemed distribution. 

The tax court said the taxpayer failed to meet the cure period deadline under the loan agreement, which expired on September 30, 2012. Because she failed to make her first loan payment by the due date and failed to make the delinquent payment before the cure period expired, she defaulted on the entire loan. As a result, the outstanding balance of the loan (including accrued interest) became taxable deemed distribution in 2012. She was also subject to the early withdrawal penalty. There is no reasonable cause exception for failing to meet the repayment requirements. 

Two lessons should be gained from this court case. 

  1. There may not be much coordination of information between payroll processing services and 401(k) service providers. Therefore, the employee may have been led to believe that everything was okay because her loan payments were being accepted and withheld by the payroll department. 

  2. Information coming to us via an online website, which may require our action to access the information is our responsibility. Lack of retrieving this information doesn’t excuse, nor provide, any relief from the penalty.

Contact me with questions or comments.

Susan A. Moussi, CPA, CFP®, CDFA SMD Tax & Divorce Financial Planning Consultants, Inc. Phone: 614.429.4172