An Internal Revenue Service (IRS) Chief Counsel Advice memo issued to assist counsel in one of the agency’s regional offices provides two ways missed 401(k) loan payments can be handled without taxing the participant in plans permitting a cure period for such skipped payments. The guidance—while neither a precedent or legally binding—may be beneficial for plan sponsors with participants who miss loan payments but seek to make them up later.
The memo, dated August 30, gives two illustrations to show how missed installment payments may be made up without penalty. One uses a later, larger payment and the other employs a replacement loan. Both situations occur within the hypothetical plan’s stated loan cure period.
Two Examples Given
Both examples are based on the facts that: (1) the 401(k) plan in question permits plan loans and allows for a cure period; and (2) that on January 1, 2018, the participant obtains a plan loan that does not exceed the allowed limit on such loans, is not a home loan, has a legally enforceable agreement, and is repayable in equal installments at the end of each month of the agreement, which is amortized over five years.
In this case, the plan’s cure period lets a participant make up a missed installment payment by the last day of the calendar quarter after the calendar quarter in which the installment was due.
As background, the federal tax code’s Section 72(p), which governs plan loans, provides that if a participant receives (directly or indirectly) a loan from a qualified employer retirement plan, the amount of the loan will be treated as having been received by the participant as a distribution from the plan. If a plan loan satisfies these requirements but payments are not made in accordance with the loan’s terms, then a deemed distribution of the loan that may be taxable occurs, the IRS memo said.
Here are the IRS Chief Counsel Advice memo’s two examples:
Situation 1: Make-Up Installment Payment. The participant makes timely loan installment payments from January 31, 2018, through September 30, 2019. The participant misses the March 31, 2019, and April 30, 2019, installments. He then makes installment payments on May 31, 2019, applied to the missed March 31, 2019, payment, and June 30, 2019, which is applied to the missed April 30, 2019, payment. On July 31, 2019, the participant makes a payment equal to three installments—which is applied to the missed May 31 and June 30 payments for the year, as well as the required July 31, 2019, installment payment.
Situation 2: Replacement Plan Loan. The participant makes on-time installment payments from January 31, 2018, through September 30, 2019. She misses the October 31, 2019, November 30, 2019, and December 31, 2019, installment payments. On January 15, 2020, she refinances the loan and replaces it with a new loan equal to the outstanding balance of the original loan, including the three missed payments. Under the terms of the replacement loan, it is to be repaid in level monthly installments at the end of each month through the end of the replaced loan’s repayment term, December 31, 2022.
The IRS memo said that in both cases the participants’ missed installment payments “do not violate the level amortization requirement under” code Section 72(p) because both are cured within the applicable cure period. “Accordingly, there is no deemed distribution of the loan due to the missed installment payments.”
It also concluded that for both situations given, the cure period permitted in the plan does not extend beyond the period set forth in Section 72(p), meaning the cure period does not go beyond the last day of the calendar quarter after the calendar quarter in which the missed installment payment was due.
If either of these actions to repay or replace the installment payments is taken after the permitted cure period ends, however, the entire outstanding balance of the loan becomes fully taxable as a deemed distribution, not just the missed installment payments alone.
The cure period, if allowed, should be included in the written plan document.
|Jane Meacham is the editor of BLR’s retirement plan compliance publications. She has nearly 30 years’ experience as a writer/editor of financial services news.|