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mperdue1431
New Member

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

My employer stop taking my payments out of my paycheck for two months to help me out financially. The payment started up again and have been doing so for more than half the year. I now have a 1099 or being taxed on the full amount of two loans saying they are defaulted even the white they are currently being repaid

8 Replies
Carl
Level 15

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

What kind of loans? Loans against your 401(k) maybe? What kind of 1099 do you have? There's 20 types. Is it a 1099-R?
mperdue1431
New Member

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

Yes, thank you! 1099R and I am still paying these back. Just missed a few
Carl
Level 15

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

Basically here's the scoop, and understand that I'm making a lot of assumptions about your loan and your 401(k), based on the "typical" scenario which very well may be your case. So if what I say here is not your case, you will need to talk with your retirement plan administrator, the lender who loaned you the money, and possibly seek the legal services of a tax attorney.

When you take out a loan "against your 401(k)", you are not actually taking money out of your retirement account. You are borrowing the money and your retirement account is the collateral you are "putting up" as a guarantee the lender will get their money. The typical terms of such a loan is, if you lose your job that provides you the 401(k) for any reason, then the outstanding balance on the loan is due and payable immediately, or within 30 days or so of your termination of that employment. Also, if you just "stop paying" on the loan for any reason, the outstanding balance of the loan becomes due and payable immediately, or after a pre-determined grace period (usually 15 days) after the payment was due.

So when you stopped paying the loan, per the terms of your loan agreement (I am assuming) the outstanding balance became due and payable in full. Using your 401(k) as the collateral, the lender then withdrew the balance due on the loan to pay that loan out. That withdrawal was authorized by you, per the terms of the loan agreement. Since it's an early withdrawal, the withdrawn amount is not only fully taxable now, it's also subject to the additional 10% early withdrawal penalty.  

So more than likely your loan was paid in full on the date of the withdrawal and there is no way you're going to get out of paying the taxes and the 10% penalty on that early withdrawal. You just have to "bite the bullet" on that.

Now for the resumption of your payments after two months, if the lender accepted those payments, that puts the lender in the wrong. This is why you may need to seek the legal services of an attorney maybe. It's perfectly possible that not only does the lender have to give you this money back you paid after the loan was paid off from your 401(k) early withdrawal, but they may have to pay it back to you with interest. It all just depends on the terms of your retirement plan, the terms of the loan agreement, as well as the laws of your state.

But at this point, the first two things you need to do is talk with the retirement plan administrator, and the lender to confirm that you were "in fact" in breach of the lean agreement, meaning that you "will" pay the taxes and penalties on the 1099-R withdrawal. More than likely, you are the one in breach of the agreement. Once you get the 1099-R confirmed as valid (and I'm highly certain it's valid, you have to report it, and you have to pay the taxes and early withdrawal penalty) then you can pursue the payments you made on the loan, after the payouff amount was taken from your 401(k).
mperdue1431
New Member

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

Thank you so much!
dmertz
Level 15

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

Stopping payments on the 401(k) and not making up the shortfall within the grace period for doing so (usually 60 days)has apparently resulted in a deemed distribution of the outstanding loan balance.  A deemed distribution is taxable and subject to a 10% early-distribution penalty unless you have a penalty exception that applies.

A deemed distribution does not satisfy the loan.  You are still required to pay back the loan.  Because you will have already paid the taxes on the outstanding loan balance, your repayments now become after-tax basis in your 401(k).  In the future when you are permitted to make distribution, each distribution will be partially taxable and a partially nontaxable distribution of your after-tax basis, so you will not be taxed twice on this money.

Carl
Level 15

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

Yes. It very well could be, depending on the plan rules, the withdrawal from the 401(k) was only to make the missed payments. But that makes the withdrawal taxable still, and subject to penalty.
dmertz
Level 15

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

A deemed distribution makes the *entire* outstanding loan balance taxable.  There is no actual distribution of the balance of the 401(k) to the credit of the employee because the 401(k) still holds the loan and no part of the outstanding loan balance is satisfied by the deemed distribution.  Only an offset distribution satisfies the outstanding loan balance and an offset distribution cannot occur until the employee separates from service with the company.
Carl
Level 15

Do I have to pay taxes on defaulted loans even though they are being paid back and there was no distribution?

It does get complicated with all the terminology, such as "deemed" and "actual" and all that stuff. Generally talking with the plan administrator can get things straight in one's head - for about 10 minutes. 🙂

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