Many 401(k) plans permit participants to borrow from the plan, and it’s becoming a more and more common practice for participants to do so. The plan document must specify if loans are permitted. The majority of those loans are repaid according to the terms of the loan agreement. However, there are instances when a participant defaults – and then it’s typically left up to the plan administrator to deal with this issue.
A loan taken from an employee benefit plan that is in default is generally treated as a taxable distribution from the plan of the entire outstanding balance of the loan (a “deemed distribution”). A company’s plan’s terms will generally specify how the plan handles the default – for example, the plan may provide that a loan does not become a “deemed distribution” until the end of the calendar quarter following the quarter in which the repayment was missed.
If a participant failed to make payments on a plan loan, the missed payments can still be made even after a deemed distribution has occurred. This correction can be made by making a lump sum payment equal to what should have been made to the plan, plus interest, reamortization of the outstanding balance of the loan over the remaining payment schedule of the original term of the loan, or a combination of either of the above methods.
Jessica Puckett, CPA, CFE