Loan in default – how to handle tax consequences

Submitted by John Dimou on Fri, 2018-02-02 16:14

The situation is I have a 401K plan with loan provision. Account balance is $10,000. Loan taken in the amount of $3,000 in 2017. Active participant and did not make any loan payments. Loan in default and received a 2017 1099R with code L.
Moving forward into 2018 plan year – account balance is still $10,000 ($7,000 with investments and the $3,000 loan).

Options are i can still payoff the loan or it continues to accrue interest.

I understand that if you are under age 55 in the year of termination there will be a 10% penalty.

Question – If i terminate employment at the end of 2018 and take a lump sum distribution, what is the mandatory withholding amount? Is it 20% of $7,000 or $10,000? Is the entire amount of $10,000 taxable or do i get the $3,000 offset since i already paid the taxes on the loan in default from the 2017 plan year?

2nd option – If i pay off the loan in 2018 and terminate employment at the end of 2018 and take a lump sum distribution, what is the mandatory withholding amount? I assume it would be the 20% $10,000 since i paid off the loan. Is the entire amount of $10,000 taxable or do i get the $3,000 offset since i already paid the taxes on the loan in default from the 2017 plan year?



Submitted by Alan - IRA critic on Sun, 2018-02-04 17:16

  1. The mandatory 20% withholding amount is 1400. Your 1099R reporting the offset distribution will be for 7000. No penalty under the age 55 separation exception.
  2. If you repay the loan in time to prevent an offset distribution, you are paying with after tax money so your basis in the plan is increased by the amount repaid. Your distribution 1099R would show 10,000, but only 7000 in Box 2a as the taxable amount. Therefore, the mandatory 20% withholding would be 1400 as above since withholding only applies to the taxable portion of a distribution. Therefore, there is no double tax paid.

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