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Attractive loans that could have hidden booby traps

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To clients who need cash, a loan from their company retirement plan can look like easy money. Credit checks are not required, so the client does not face a lengthy approval process, and the interest rates available on plan loans are often very favorable. Such a loan can be a good option for a client with problems getting credit at an affordable rate.

But these loans carry some danger as well. There are a variety of complex rules that must be followed, and breaking those rules can have serious tax consequences. A loan that is considered in default is deemed a distribution of the retirement plan. This results in the balance being taxable and possibly subject to a 10% early distribution penalty.

This is just what happened in an important recent tax court case involving a California couple who defaulted on 403(b) plan loans taken to avoid foreclosure.

Let’s take a look at details that should be considered when clients have a retirement plan that give them the opportunity to borrow money from their accounts. Loans are much more likely to be allowed in defined contribution plans than in defined benefit plans. Loans are not available from IRAs, including SEP and Simple IRAs.

Plan loans are not a no-strings-attached deal. In general, there are three conditions that must be met to prevent the loan from being deemed a distribution.

1. The loan balance must be repaid within five years (an exception exists for loans used to aid in the purchase of a principal residence).

2. The loan must be repaid using a substantially equal level of amortization, with payments no less frequently than quarterly. In other words, if you took a $5,000 loan from your plan and were paying it back quarterly over five years, each payment should be $250 (ignoring interest). You could not make 19 quarterly payments of $100 and then one final payment of $3,100.

3. The loan balance also may not exceed certain limits. It must be the lesser of: $50,000 (reduced if applicable, by the highest outstanding loan balance from the year prior to a new loan) or the greater of $10,000 or one-half of the vested account balance.

The requirement that a plan loan be repaid within five years does not apply to a loan used to acquire a principal residence. In general, mortgage refinancing cannot qualify as a principal residence plan loan. The other requirements for plan loans still apply.

What happens if a payment is missed on the loan? The plan terms will generally specify when a default is said to occur. A plan may provide a “cure period,” or grace period, if a payment is missed.

A cure period can provide that a loan doesn’t become a “deemed distribution” until the end of the calendar quarter after the quarter in which the repayment was missed. For example, Ann took a loan from her 401(k). If she missed a payment due March 31, the end of the first quarter of the year, she would have until the end of the second quarter, June 30, to bring the loan current. If she does not, the loan will be treated as a distribution on June 30.

A cure period can provide that a loan doesn’t become a “deemed distribution” until the end of the calendar quarter after the quarter in which the repayment was missed.

Not all plans have the maximum cure period allowed under the law. Some may not have a cure period at all. Advisers should be sure to check plan documents to determine exactly when a loan is treated as a distribution.

Generally, a defaulted loan is considered a deemed distribution. The plan reports the outstanding loan balance on Form 1099-R with the designation Code L in Box 7. A deemed distribution isn’t offset from the participant’s account. This unpaid amount will remain recorded as an outstanding loan by the plan until a distribution can occur under the plan’s terms. A deemed distribution is taxable and subject to the 10% early distribution penalty. A deemed distribution is not eligible to be rolled over to IRA.

Clients can still make up missed payments even after a deemed distribution has occurred. In that case, their basis under the plan is increased by the amount of the late repayments.

What happens if a client has a loan and leaves his job before he repays it? Now that he doesn’t work for that employer, he is probably eligible to receive a distribution of his plan balance. But what about the unpaid loan?

Very few plans want to handle loan payments from individuals who no longer work for the company. Generally, the client will be given 60 days to pay off the loan balance. During that time, the client can, for example, get a bank loan to pay off the plan loan.

After the grace period, if he hasn’t paid the loan, the plan will do a “loan offset,” whereby the unpaid loan balance will be subtracted from the plan balance. The loan offset amount is reported as a distribution on Form 1099-R. The distribution is taxable and may be subject to the 10% early distribution penalty.

The client can avoid taxes and penalties by rolling over the loan offset amount to an IRA within 60 days. He’ll have to come up with the cash from personal assets or a bank loan, but at least he has an opportunity to avoid taxes on the offset amount. If the client doesn’t repay the outstanding balance, it is treated as a distribution.

In the recent case (Dora Marie Martinez et vir v. Commissioner, T.C. Memo. 2016-182; No. 8483-15, Sept. 28, 2016), Dora Marie Martinez worked as a public school teacher in Los Angeles. Her husband, Carlos Garcia, was a truck driver. The couple had some financial problems and faced foreclosure on their home in 2010.

To save their home, Martinez decided to borrow from her 403(b) retirement plan. She requested two loans from her plan. Each loan agreement indicated that the loan was to be repaid in quarterly payments over a five-year period. The loans also included language in all capital letters stating that the new loan was “not to be used as a residential loan.” She signed both loan agreements.

Martinez made some payments on the loan but could not keep up and stopped payments. As a result of her default, the plan deemed the loan balances, $20,581.85 and $2,906.92, respectively, to be taxable distributions in 2012. The deemed distributions were reported on a 2012 Form 1099-R as fully taxable with a distribution code of L, designating a deemed distribution.

On their jointly filed 2012 federal income tax return, Martinez and Garcia reported only their wage income. They did not report income from the deemed distributions. They also did not report income from various other sources totaling about $1,000.

The court held that because Martinez failed to make loan payments after May 2012 and did not repay these missed amounts within the cure period, the loan balances were deemed taxable distributions in 2012.

They did not report income from the deemed distributions.

The court reminded Martinez that tax regulations establish the timing and amount of a deemed distribution. A retirement plan participant's loan from her retirement account is essentially a debt to herself. The participant has borrowed her own money. If a participant should fail to repay, the administrator has no personal recourse against her. Instead, the regulations require that the plan deem the outstanding loan balance to be a distribution of funds.

The court also struck down Martinez’s argument that there was no deemed distribution because the loans were used to acquire a principal residence.

And it had more bad news for Martinez and Garcia. It said that they owed the 10% early distribution penalty on the deemed distributions from the plan because Martinez was 43 years old in 2012 when the distributions were received. The court also said that taxes were owed on the approximately $1,000 in taxable income from various sources that was not reported. To top it off, the court also hit Martinez and Garcia with the 20% accuracy penalty.

This case shows why you should be cautious about seeking a retirement plan loan. In most instances, plan loans should be a last resort. Advisers who have clients considering such loans should make sure that the client understands all of the loan and tax provisions and the potential penalties if the loan cannot be repaid.

Also, be careful with clients who want to take plan loans when their employment may not be secure. The best option for loan repayments is to have the payments automatically withheld from the paycheck whenever possible.

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