Taxation of Outstanding 401(k) Loan
My client was participating in a 401(k) at his employer but recently terminated. On the date of termination he had an outstanding loan balance. He was 59 years and 5 months old on his termination date. Could he avoid the 10% penalty on the outstanding loan by waiting another month before requesting a rollover of his remaining balance? Or is the distribution date of his loan the same as the date he terminated employment? Thank you.
Permalink Submitted by Alan - IRA critic on Tue, 2014-04-29 20:06
He needs to determine if the plan has issued a “deemed distribution” prior to termination. These are coded “L” on the 1099R and cannot be rolled over. The penalty will apply unless he qualifies for a penalty waiver. But he cannot use the age 55 separation exception because the deemed distribution would have come prior to the separation. On the other hand, if there has been no deemed distribution, the plan would offset the loan using an “offset distribution” and if he could raise the funds, he could roll over the plan balance to an IRA and eliminate tax and penalty. Of course, if he has the funds, he probably would have paid off the loan by now. An offset distribution is treated as an actual distribution, and if “early” will be coded “1” on the 1099R. There would be different 1099R from the rollover because of coding differences since the rollover would be a direct rollover and the loan amount is a distribution. Client should get these options in writing from the plan. The 1099R for the loan amount might be coded as a normal distribution if done after age 59.5 and if so there would be no penalty.
Permalink Submitted by Martin Helmer on Tue, 2014-04-29 23:12
The penalty likely does not apply. Deemed distribution date occurs when the loan fails to meet section 72(p), either in form or operation. Most loans nowadays are repaid via payroll deduction. Most deemed distributions then occur after separation from service, when we get to the first payday for which the ex-employee fails to make the required installment. Most plans, but not all, will not accept payment unless it’s payroll. Some plans allow a grace period that might extend to the end of the quarter following the missed payment, before the deemed distribution occurs. But what good is that if you can’t make repayment with personal funds? An offset could occur in the meantime, if ex-employee receives distribution of his entire net account before the deemed distribution kicks in. Either way, no penalty. But if it is an offset (when the principal balance theoretically can be rolled), be aware the plan might withhold 20 percent of the principal from your net, because you are not in fact directly rolling over the principal.