Navigating Retirement Plan Loans: A Case Study

The allure of tapping into retirement savings during financial emergencies using retirement plan loans often becomes an attractive option. However, without the proper guidance or understanding of the complexities involved, it can lead to unintended financial repercussions, as evidenced by two specific Tax Court cases.

David’s Dilemma: A Genuine Hardship, Yet No Exceptions in Tax Law

Background: In 2011, David, a 49-year-old, took a loan of $36,248 from his 401(k) account, well within the allowed limit of the lesser of $50,000 or 50% of the plan balance. Unfortunately, David faced a job layoff later in the same year. To maintain financial stability and avoid becoming “a burden on society,” David requested a plan distribution of $127,140. From this distribution, a tax of $18,000 was remitted to the IRS, and the outstanding plan loan was repaid, leaving David with $73,490.

Challenge: Although David reported the distribution accurately on his 2011 income tax return, he omitted the additional 10% tax due for plan distributions taken before the age of 59 ½. With a backdrop of genuine economic hardships, including over $9,000 in unreimbursed medical expenses for the family, David hoped the Tax Court would provide a reprieve.

Outcome: Despite empathizing with David’s situation, the Tax Court ruled that the tax code does not accommodate a “hardship” exception for premature plan distributions. Furthermore, David’s assumption that the 10% penalty wouldn’t apply to his loan was incorrect. The court ruled that the penalty also applies to loan forgiveness, making it a “deemed distribution” from the plan, taxable in the year of loan forgiveness.

Harold’s Boundary Breach: The Complexity of Plan Loan Limits

Background: Harold, a participant in the New York State and Local Retirement System (NYSLRS), accumulated savings of $17,017 over the years. In 2009, Harold requested a “maximum loan” from the plan and received $5,993, bringing his total loan balance to $12,802.

Challenge: The IRS determined that Harold’s loan exceeded the permissible amount by $2,802, which was treated as taxable income. Moreover, the IRS claimed a 10% tax on premature distributions for this excess amount. The core issue rested on who bore the burden of proof regarding Harold’s age—whether he was above 59 ½ to be exempted from the additional tax.

Outcome: The Tax Court clarified that the additional 10% tax is indeed a tax, not a “penalty,” as perceived in common parlance. This distinction shifted the burden of proof to Harold. Without evidence of being over 59 ½, Harold was obligated to pay the additional 10% tax on the excess loan amount. Notably, the 10% tax also pertains to the income tax paid.

Lessons Learned and Best Practices

Navigating the intricacies of IRA distributions has proven challenging for many. To safeguard oneself:

• Always file Form 5329 alongside Form 1040 when a distribution is made, ensuring clarity and compliance.
• Maintain IRA records indefinitely, aiding in resolving potential discrepancies in the future.

While retirement plan loans may seem like an immediate solution during pressing times, understanding the nuances is critical. As David and Harold’s experiences show, making informed decisions is crucial, emphasizing the value of professional guidance in navigating complex financial situations.

If you are a Legacy client and have questions, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or connect@lptrust.com.

This newsletter is provided for informational purposes only.
It is not intended as legal, accounting, or financial planning advice.