Retirement plan loan treated as distribution

[BP.]

Client is repaying a loan from her employer's retirement plan. The loan was taken out before age 59 1/2. If she defaults or leaves employment, the outstanding loan balance will be treated as a taxable distribution.

The questions are: If the default occurs prior to age 59 1/2, does the 10% penalty apply? And if the default occurs after reaching age 59 1/2, will the taxpayer then escape the 10% penalty? Thx!

[jimmcg]

Client is repaying a loan from her employer's retirement plan. The loan was taken out before age 59 1/2. If she defaults or leaves employment, the outstanding loan balance will be treated as a taxable distribution.

The questions are: If the default occurs prior to age 59 1/2, does the 10% penalty apply? And if the default occurs after reaching age 59 1/2, will the taxpayer then escape the 10% penalty? Thx!

Without researching it for code or precedent I would think that your two answers are yes and yes.

[Burke]

That is correct. However, if she intends to leave employment, they usually notify her that she has an option to pay the loan off within a specified period of time. Then she can borrow the money elsewhere and pay off the loan. Distribution can be rolled over until she is 59 1/2, or she can leave funds with employer until then in most cases.

[BP.]

Thank you both, jimmcg & Burke.

Her plan seems to be to skip paying on the loan after turning 59 1/2 in order to create a default, which'll in turn create the "loan treated as distribution" situation. And so she wondered about the 10% penalty application. I'll tell her she'll escape the penalty.

Any idea if or where this is dealt with in the relevant pubs? Would like to have a page printed for the file, but I haven't turned up anything just yet.

[Jesse]

Try these links:

http://www.sheridanrepublic.com/forms/EA%20IRS%20Reg%2072p%20Loan%20Default.pdf

http://www.irs.gov/retirement/article/0,,id=162415,00.html#4

[BP.]

Thx, Jesse- very nice!