Deemed distribution "defaulted" 401-K loan ?

[artp]

Client (company manager) was injured in auto accident (company auto) in July 2010 which resulted in substantial time off due to his injuries. The other driver was at fault and is paying claim damages. He tried to perform what functions he could, but was unable to work and was placed on worker’s comp. His medical bills have been covered so far by the other driver’s insurance company and his medical policy with his employer.

In Aug he borrowed money (40K)from his 401-K at the company to cover living expenses. He requested that his employer allow him to make payments on the loan while he was on workers comp (his wife has a job), but they refused. When he was released to go back to work in Dec 2010, his company terminated him immediately, claiming loss of business during the current economic downturn.

He has only recently been able to find employment, Meanwhile, the administrator for the 401-K plan sent a letter in March 2011 threatening to treat the loan as delinquent which according to them would mean that it would be a deemed early distribution and be subject to 10% penalty since he does not meet any of the exceptions. So far he has not officially been notified that the loan is indeed in default.

1. Is this the correct treatment for a “defaulted” 401-k loan?

2. Can the company refuse to allow repayments on 401-K loans when an employee is on worker’s comp and is not receiving a pay check from the company?

I suggested that my client contact the plan administrator to see if some payment arrangement could still be worked out to avoid a taxable distribution and the accompanying penalty. He is also pursuing legal action against his former employer. Has anyone come across a situation like this in their practice ? Any suggestions would be welcome.

Thanks,

Art

[jainen]

>> threatening to treat the loan as delinquent<<

Nothing to threaten--by definition the loan has already defaulted if he missed a payment. Generally the terms of a 401(k) loan require payroll deductions; one of the most important and well-known risks is that losing your job means you have to immediately repay the entire amount.

[artp]

>> threatening to treat the loan as delinquent<<

Nothing to threaten--by definition the loan has already defaulted if he missed a payment. Generally the terms of a 401(k) loan require payroll deductions; one of the most important and well-known risks is that losing your job means you have to immediately repay the entire amount.

Jainen,

Thanks for the quick reply. I was hoping we might find another solution. Client will have a 5K refund coming on this year's return and might be able to find a way to finance the rest.

Art

[Pacun]

You have a lot of time for tax planning. The distribution paper will be issued in 2011. Ask him to put whatever his is willing to repay on an IRA and he will mitigate the taxes he will be paying next year.