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Case of the Week: Repayment of Defaulted Plan Loan After Deemed Distribution

The ERISA consultants at the Columbia Management Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with a financial advisor in Washington is representative of a common question related to participant loans taken from qualified retirement plans.  The advisor asked:  

“My client has defaulted on a loan he took from his 401(k) plan and the plan administrator said it would treat the outstanding amount as a deemed distribution. Should my client still repay the loan to the plan?”   

Highlights of Recommendations 

  • Yes, despite a deemed distribution of a defaulted loan, the amount is still included as a plan asset and continues to accrue interest until the participant has a distribution-triggering event that would allow the plan administrator to offset the outstanding loan amount against the participant’s plan balance (i.e., an actual distribution) (Treasury Regulation Section 1.72(p)-1, Q&A-19). Until then, the participant is still obliged to repay the outstanding loan amount following a deemed distribution.
  • Since a deemed distribution of a loan is taxable to the participant, any loan repayments to the plan after a deemed distribution has occurred create (or increase) the participant’s tax basis under the plan (Treasury Regulation Section 1.72(p)-1, Q&A-21).
  • Though the amount of such loan repayments creates a tax basis in the plan for the participant, repayments are not classified as after-tax contributions for purposes of the actual contribution percentage test (which includes matching and standard employee after-tax contributions), nor are they included in the participant’s Internal Revenue Code Section 415 “annual additions” limit.

Conclusion

A deemed distribution of a qualified plan loan has unique characteristics.Plan participants still have a responsibility to repay a plan loan that is deemed distributed but is still on the books. It is important to understand how such repayments are treated for tax and testing purposes. 

The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2014 Columbia Management Investment Advisers, LLC. Used with permission.

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