This article is reproduced with permission from Spidell Publishing, Inc.
For many people, taking out a loan from their 401(k) can help them during some tight financial times. If done properly, it enables them to access their savings for a short period of time, and any interest paid is paid back to their 401(k) rather than to a bank or other creditor. But, if taxpayers fail to comply with the terms of the loan, they will face the following adverse consequences:
- if the taxpayer fails to repay the amount during the applicable cure period, the full amount of the loan will be deemed to be distributed in the year of the failure;
- unless an exception applies, a 10% early withdrawal penalty will be imposed; and
- if taxpayers may find themselves liable for an accuracy-related penalty.
Two recent cases illustrate these consequences.
Employer’s failure to make payroll deductions
In Frias v. Comm., the taxpayer took out a $40,000 loan from her 401(k) on July 27, 2012, when she went out on a 10-week maternity leave. She received accrued sick, personal, and vacation leave, which covered about five weeks of her leave, but the remainder of her leave was unpaid. Per the terms of the loan agreement, her employer was to make $341 in payroll deductions to repay the loan, but unfortunately for Ms. Frias, her employer failed to make the deductions. Under the loan’s terms, Ms. Frias could repay the delinquent amounts up to the last day of the following calendar month (cure period).
When she returned to work, she was told that the payments were not made. She immediately made a payment of $1,000 on November 20, 2012, and increased her loan repayment amount to $500 per month to catch up. The 401(k) administrator continued to accept the payments, and on July 9, 2014, sent Ms. Frias a letter stating that her loan had been repaid in full. The plan administrator sent the IRS a Form 1099-R for 2012, showing a taxable distribution to Ms. Frias in the amount of $40,065. Ms. Frias stated she never received a copy of the 1099-R.
The Tax Court ruled that because Ms. Frias failed to make a payment in August 2012 and did not make a cure payment during September 2012 (the cure period), the entire loan was deemed distributed in 2012. Ms. Frias argued that she fell within an exception to make the required payments because she was on unpaid leave. However, the court ruled that accrued sick, personal, and vacation pay is pay and that she did not qualify for the bona fide leave exception because the pay she received was for amounts greater than the required installment payments. The court ruled that she was not liable for the accuracy-related penalty because she reasonably believed that she did not default on the loan. Neither her employer nor the plan administrator gave any indication that she had actually defaulted when they allowed her to continue making payments. The court also believed that she did not receive a copy of the 1099-R.
CPA gets the “cure period” wrong
A CPA, who is a tax specialist and had worked for Ernst & Young, PricewaterhouseCoopers, and KPMG, had taxable income and a 10% additional tax on a defaulted plan loan. The income was taxable in 2012 and not in 2013, the year he argued was the end of the “cure period.”
On March 8, 2012, the taxpayer borrowed $50,000 from his 401(k) plan at KPMG. The terms of the loan required him to make 120 semimonthly payments of $451.72 beginning March 30, 2012. According to the terms of the loan, the cure period expired at the end of the calendar quarter following the calendar quarter during which the payment was missed. After he lost his job at KPMG, he stopped making payments, beginning with the payment due August 30, 2012. Because the payment was missed in August (third calendar quarter), the cure deadline was December 31, 2012, the last day of the fourth quarterly.
The taxpayer tried to argue that basing the cure period on strict calendar quarters did not make sense and was unfair. “For instance, somebody was unemployed in June would actually get six months of cure period, versus somebody who would get laid off in August, as I was. That only gets four months of cure period. [sic]”
The taxpayer followed up on this logic by stating that the first quarter should start in the month of the initial default (August), so the first quarter would consist of November, December, and January. The cure period would then end in January 2013, and the distribution would be in tax year 2013. The court made short work of this argument and pointed to the regulation that provides that the cure period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment was due. Because the last day of that following quarter was December 31, 2012, the distribution was taxable in 2012. The court also found that the taxpayer did not have reasonable cause for reporting the distribution in the wrong tax year and upheld a $5,876 accuracy-related penalty.
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