By Andy Ives, CFP®, AIF®
A word we don’t see much in daily conversation is “deem.” I imagine a sweeping proclamation made by an authority figure from an ivory tower: “It is deemed that the third day of the standard workweek shall henceforth be called ‘Wacky Wednesday.’” While working “deem” into a sentence among friends can be tough, and you might get some sideways looks, the IRS has no such difficulties.
“Deemed distributions” come to mind. When a retirement plan loan goes bad, a deemed distribution can rear its ugly head.
A participant in a workplace retirement plan cannot take money from the plan willy-nilly. There are rules in place and consequences should one go astray. For example, participants may receive a nontaxable loan of up to 50% of their vested account balance, with a maximum loan amount being the lesser of 50% of the vested account or $50,000. That means if someone has a vested account balance of $120,000, the maximum loan amount is $50,000. On the other hand, if the vested account is only $80,000, the maximum loan limit is $40,000.
Typically, the loan must be repaid within 5 years. (The five-year repayment period may be exceeded if the loan is for the purchase of a primary residence). Repayments (which includes principal and interest) must be made at least quarterly, though the plan can require them more frequently (i.e., bi-weekly, monthly, etc.).
If a participant is in violation of any of the above, the IRS waves their Scepter of Decision and proclaims a “deemed distribution.”
Example #1: Jimmy takes a loan from his 401(k) plan for $60,000 to start a business. This triggers a $10,000 deemed distribution.
Example #2: Sally takes an $8,000 loan from her employer plan to pay off debts, but the repayment period is erroneously set for six years. This repayment term mistake creates a deemed distribution and causes the full $8,000 to become taxable.
Example #3: Sally takes the same $8,000 loan over the proper five-year timetable, but the repayment schedule is set for five annual payments (as opposed to the quarterly minimum). Again, the full $8,000 is labeled a deemed distribution and becomes taxable.
But do not fret! If the normal (5-year) maximum repayment period has not expired in the above examples, these mistakes can be fixed. Jimmy can work with his plan administrator to repay the excess, plus interest. (He cannot roll the excess $10,000 into an IRA.) Sally can re-amortize her loan over an allowable schedule, and loans that are deemed in default can be corrected with a lump sum payment equal to what should have been made to the plan, plus interest. However, bear in mind that many plan loan mistakes can only be corrected if the plan files for relief under the Voluntary Correction Program (“VCP”). The VCP not only requires an IRS filing, but also payment of the applicable user fee.
In the end, know the rules for plan loans, and work closely with the plan administrator to correct any potential mistakes. The IRS provides “Fix-it Guides” and tips to avoid common retirement plan errors on their website at: https://www.irs.gov/retirement-plans/correcting-plan-errors
Otherwise, enjoy Wacky Wednesday, and I deem this article finished.