John R. Bullis: Default qualified retirement plan loans are taxable income
December 6, 2016
The Tax Court found Dora Marie Martinez failed to repay a loan from her qualified retirement plan (sec. 403(b) plan). The failure to repay is deemed to be a taxable distribution. The amount owed for the loan is taxable income that is to be reported on her individual income tax return.
Further, since she was "young" (only 43 years old) and no exception applied, she had to pay an additional 10 percent of the loan amount as a penalty for "early withdrawal."
A loan from a qualified retirement plan (including 401(k) plans) is treated as a distribution unless:
The loan does not exceed the lesser of $50,000 or 50 percent of the vested benefit.
The loan is to be repaid within five years unless it is a principal residence loan.
The loan is amortized in basically equal payments (monthly or quarterly payments).
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Mrs. Martinez was a teacher in the Los Angeles Unified School District. She received loans Aug. 12, 2010, of $28,899 and $4,085. She signed loan agreements that required the loans were to be repaid over five years in quarterly payments. She signed the agreement that the new loans were not to be used as residential loans.
She made some repayments but stopped paying in May 2012. Her father died, the home faced foreclosure and in 2014 her son had cancer. She did not report the deemed distributions as taxable income in 2012. The balances owed in May 2012 were $20,582 and $2,907. So she should have reported taxable income of $23,489 in 2012 and paid 10 percent penalty for early withdrawal.
The court found she failed to repay the loans and she did not meet any of the exceptions listed in the tax code or the regulations. It also found she owed the 10 percent penalty for early withdrawals.
This is just another example of a taxpayer taking a losing case to Tax Court. That is not a good idea.
If she had been aware of the tax code and regulations, she would have understood her case would be lost. It was a waste of time and money for her to go to Tax Court.
She did not present evidence for $1,300 spent for her daughter's college costs until the trial. That is a mistake. She should have given that evidence to IRS long before it was even set for trial. So the Court did not consider that evidence. An experienced tax attorney would have helped her give the evidence to IRS in a timely manner. Most importantly, an experienced tax attorney would have explained she was bound to lose the case.
Did you hear? "The difference between perseverance and obstinacy is that one often comes from a strong will and the other from a strong won't," by Henry Ward Beecher.
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.