Two recent cases involving New York City employees illustrate how retirement plan loan provisions are more complex than they first appear, and how violating any of them can lead to serious tax consequences.
One case involved Vincent Marquez, an emergency medical technician who participated in the New York City Employees' Retirement System. Over the course of his employment, Mr. Marquez took a number of loans from the plan, generally electing to take the maximum amount allowable and the minimum repayment requirement.
In May 2005, Mr. Marquez applied to refinance his outstanding loan balance and elected an option that would provide him $12,346.95. The new loan would be used to pay off his existing loan balance of $7,716.95 and provide him with an additional $4,630 in cash. According to the terms of the loan document, the new loan would be paid back over five years through 130 biweekly payroll deductions.
During the application procedure, Mr. Marquez received a loan processing document from the retirement plan sponsor that explicitly stated that the refinancing option he chose would likely result in taxable income.
Despite receiving these warnings, Mr. Marquez chose to proceed with his original loan request. He was subsequently issued a Form 1099-R from the New York retirement system for $10,032, but failed to report the income on his tax return. Following an audit, the IRS determined that the failure to report led to a tax deficiency of $2,346 and issued a notice as such. Mr. Marquez disagreed with the IRS's findings, stating that he was below the $50,000 maximum loan limit for his plan. The two sides ended up in court.
The Tax Court agreed with the IRS, and upheld that the refinanced loan received by Mr. Marquez subjected him to a $10,032 deemed distribution that should have been included in his income. To compound the issue, the Court also found that Mr. Marquez, who was under 59½ at the time, could not show that any exception applied that would exempt him from the penalty for early distributions. As such, the court concluded that the 10% penalty for early distributions applied to the total distribution as well.
In another case, Michael Billups, an employee of the New York City Transit Authority, had been taking various plan loans from his retirement savings for more than 10 years, but had conformed with loan limits and was current on all payments.
In April 2005, Mr. Billups refinanced his existing loan with a new $39,748.06 loan, which he used to repay his outstanding loan balance and to provide him with $12,630 in cash. At the time, his annuity account balance was $52,863.38.
Upon completing the paperwork to facilitate the new loan, Mr. Billups was advised by NYCERS that his new loan could potentially lead to all or a portion of the outstanding balance becoming taxable. Nevertheless, Mr. Billups decided to move forward. At the end of the year he was issued a Form 1099-R for $29,467 showing a distribution code of L1, for a loan deemed a distribution.
Mr. Billups had his 2005 tax return prepared by a professional accountant, to whom he gave the 1099-R showing the distribution. The return, however, designated the distribution as a rollover and not a deemed distribution from a plan loan, as was indicated by the L1 code.
The IRS caught the mistake and issued Mr. Billups a notice of deficiency stating he owed $12,059 in unpaid income tax (including the 10% penalty for early distribution). Mr. Billups disagreed with the IRS's notice and the case made its way to court. The Tax Court determined that Mr. Billups had, indeed, exceeded his maximum allowable loan limit and that the excess was correctly deemed a distribution from the plan. As a result, he owed both the income tax and the 10% penalty.
The moral of both stories is to handle retirement plan withdrawals very carefully. Plan loans have been around for many years, but with a weak economy and high unemployment it's likely that more clients will be in need of cash. This may lead clients to take new or larger loans from company plans. Make sure to remind clients that retirement plan loans can be taxable, so they can avoid problems and keep more money in their pockets and out of Uncle Sam's when they need it the most.
Ed Slott, a certified public accountant in Rockville Centre, N.Y., created the IRA Leadership Program and Ed Slot's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.
