When a Plan Loan Turns Into a Taxable Distribution

Take-Away: Some qualified plans permit plan participants to take loans from their retirement account. If the participant fails to repay an installment in a timely manner, the loan will be treated as a taxable distribution of the loan balance and possibly trigger the 10% penalty for an early distribution.

Background: Amounts distributed to a plan participant from a qualified retirement plan are subject to taxation. [IRC 402(a).] This taxation also occurs with a loan from a qualified employer plan, will be treated as a taxable distribution. [IRC 72(p) (1) (A).] There are exceptions, however, when the loan does not exceed a specified dollar limit. In order to qualify for the statutory exception, either the loan must be repaid within 5 years from the date of the loan’s inception [IRC 72(p) (2) (A)]; or, the loan is used to finance the acquisition of a home that is the principal residence of the plan participant [IRC 72(p) (2) (B)]; or, the loan is subject to substantially level amortization with quarterly or more frequent payments required over the loan’s term. [IRC 72(p) (2) (C).] The plan administrator may permit a grace or cure period in the event of an overdue payment, but even with a grace period, the delayed payment cannot continue beyond the last day of the calendar quarter in which the required installment payment was due. If the plan participant fails to make a loan payment either on the date that it is due, or within an allowed grace period, the loan from the qualified plan no longer satisfies any of the statutory exceptions, which will result in a taxable distribution. An example of the inflexible grace period rule is a recent Tax Court decision.

Reported Decision:  McEnroe v Commissioner, Tax Court Summary Opinion (2019-21, August 20, 2019.)

Facts: Gerald, age 51, had been employed by the Office of Inspector General of the New York City School Construction Authority for about 15 years. Gerald participated in the New York City Retirement System. In 2014, Gerald borrowed $26,045 from his retirement account to help pay his child’s college tuition. Gerald immediately began to repay this plan loan through biweekly payroll withholding. On May 15, 2015, Gerald left his employment to begin to work at a job in the private sector. After he left the Inspector General’s employment Gerald ceased to make payments on his plan loan. Gerald promptly grew disillusioned with his new job in the private sector, he quit that job, and he promptly returned to his employment in the Office of Inspector General in September 2015. On his return to public employment, Gerald learned that his outstanding loan balance was treated as a taxable distribution. Gerald contacted the HR department in search of a solution. On November 15, 2015, the HR department sent an email to the plan administrator, which said, in part, “Be advised that Mr. McEnroe wishes his outstanding loan to be reinstated with installment payments effective immediately. Mr. McEnroe had left the SCA for a brief period of time and as such, payments were not being withheld. A notice of distribution was subsequently sent to his home. As Mr. McEnroe is now once again an active SCA employee he would like his loan not to be treated as a distribution and to repay in bi-weekly payroll deductions.  Please.. confirm this loan will not be treated as a distribution.” The plan administrator responded with an email saying: “we will process a revision and it will be done for 11/20/15.” In December 2015, Gerald resumed making loan payments to the plan through payroll withholding. Gerald received a 1099-R for 2015 for $22,284, the outstanding balance of his loan, as of June 24, 2015, plus accrued interest. Gerald filed his Form 1040 for 2015 refusing to report the $22,284 in taxable income for the year (not said in the Court’s decision, but presumably based upon the email exchange between the plan administrator and the HR department in December 2015.)

Issue: The IRS taxed Gerald on the distribution with the 10% excise tax for the early plan distribution to him. [IRC 72(t).] Gerald argued that he did not receive any taxable distribution because he had ‘successfully reinstated’ the loan and resumed the loan repayments beginning in December 2015.

Tax Court: The Tax Court found Gerald to have received a taxable distribution from his qualified plan account. The Court cited two reasons why Gerald was wrong.

• First, Gerald had failed to make loan payments that were due ‘over a roughly six-month period, stretching from June to December 2015.’ Gerald’s first defaulted payment was in June 2015, which fell in the second calendar quarter. The qualified plan’s grace period would have expired no later than September 30, 2015, the last day of the third calendar quarter. [Treasury Regulation 1.72(p)-1, A&A-10(a).] Gerald did not resume making loan payments until December 2015.
• Second, Gerald made no effort to cure any earlier default in his loan payments, e.g. no lump sum payment was made by Gerald to cover the many installment payments, with accrued interest, that he had missed during that 6-7 month period. Accordingly, Gerald was treated as having received a deemed distribution from the qualified plan.

In response to Gerald’s argument that it would be inequitable to impose the 10% excise tax for an early distribution from the qualified plan, especially since the plan administrator never provided to him any notice that his plan loan was considered to be in default, and in any event he acted reasonably and in good faith when he resumed his loan repayments, the Tax Court merely said that there is no authority in the Tax Code, or any case law, for an equitable or hardship exception to the taxation of deemed distributions when loan payments are missed, nor any hardship exception to the imposition of the 10% excise tax for early distributions: “The Court may not add an exception to the Code by judicial fiat, and we are obliged to apply the law as written.”

Conclusion: Gerald seemed to be an honorable person with the best of intentions. The loan proceeds were used to pay for his child’s college expenses and not a red sports car. Apparently those honorable intentions over a 6 ½ month period were not enough to spare Gerald from the consequences of a deemed taxable distribution and a 10% penalty. Perhaps the best news for Gerald was that he only borrowed $26,045 from his qualified plan account. Not all qualified plans permit loans to be taken from a retirement account. For those that do permit loans, a participant needs to think twice before taking a loan, as the rules that govern repayment of the loan are extremely inflexible.