Many 401(k) and other employer retirement plans allow participants to borrow from their accounts. These loans can carry a number of advantages, including ready availability and a reasonable rate of interest. Moreover, if properly structured, a participant loan can be obtained (and repaid) on a tax-free basis.
On the other hand, the failure to comply with the Tax Code’s constraints on participant loans can subject a borrowing participant to immediate income taxation and, if the participant is not yet age 59½, a 10% penalty tax. Two recent Tax Court decisions highlight one aspect of these participant loan rules that can easily be overlooked, thereby subjecting participants to these adverse tax consequences.
Both of these cases arose under the same plan, the New York City Employees’ Retirement System (“NYCERS”), and both involved participants who chose to refinance existing loans by increasing the loan amount and extending the original repayment term. As explained below, this extension was what triggered the dispute with the IRS.
Under Section 72(p) of the Tax Code, any participant loan will be treated as a taxable distribution unless the following three conditions are satisfied:
- The principal amount of the loan (when added to the outstanding balance of all other loans to that participant from plans sponsored by the same employer) does not exceed a specified limit;
- The loan, by its terms, must be repaid within five years (with an exception for home acquisition loans); and
- The loan must be repaid through substantially level amortization, with payments no less frequently than quarterly.
The loan limit is generally equal to the lesser of $50,000 (reduced to reflect any loans outstanding during the one-year period before the new loan is made) or one-half of the participant’s vested account balance.
The IRS regulations issued under Section 72(p) discourage the use of refinancing as a way of extending the term of an existing loan. They do so by providing that, where an existing loan is replaced by a loan having a later repayment date, both loans must be treated as outstanding on the date of the new loan. If the sum of these loans (along with all other outstanding loans to the same participant) exceeds the limit described above, the replacement loan will result in a deemed distribution equal to the amount in excess of that limit.
In both of these recent cases, the participant opted for a new loan that not only increased the amount of an existing loan, but also extended the repayment term of that loan. NYCERS cautioned both participants that this would likely result in a portion of the new loan being treated as taxable income. It also reported that taxable portion on a Form 1099-R.
When the participants failed to report this amount as taxable income on their personal tax returns, the IRS issued income tax assessments. Moreover, because both participants were under age 59½, the IRS assessed the 10% penalty tax.
In both cases, the Tax Court agreed with the IRS that the extended term of the new loan triggered the regulatory requirement that both the existing and new loans be treated as outstanding on the date of the new loan. This caused the Section 72(p) loan limit to be exceeded. The court therefore upheld the IRS’s determinations as to both the income and penalty taxes.
Both of these participants could have obtained an additional loan on a nontaxable basis – had they been willing to continue making payments on the existing loan in accordance with the original payment schedule. Plan administrators should be prepared to advise participants of the potentially adverse tax consequences of extending an existing loan, as well as alternative approaches that might achieve a participant’s goals without triggering these taxes.