Missed 401(k) loan payment proves costly for employee on maternity leave

September 5, 2017|James Derzon

Remember to carefully review each paycheck. You are ultimately responsible for any loan payment deductions, and this cautionary tale illustrates how quickly things can go awry.

Here’s a tale,

Sad but true,

Check your payroll,

So it won’t happen to you.

The U.S. Tax Court recently held that Mrs. Louelia Frias owed $15,941 in income taxes and was subject to an early distribution penalty of $4,000 because she missed her first biweekly 401(k) loan payment of $341.79, even though:

  • The error was due to the fault of her employer and the plan’s third-party administrator, and
  • Mrs. Frias, upon discovery of the problem, increased her loan payments and ultimately paid off the entire amount of a $40,000 plan loan!

Here are some facts

Mrs. Frias took out a $40,000 plan loan on July 27, 2012. On July 30, 2012, she began her maternity leave and returned to work on October 12, 2012.

Mrs. Frias used accrued sick, personal and vacation leave to cover the first five weeks of her maternity leave. The remainder of the maternity leave was unpaid.

When Mrs. Frias took out the $40,000 loan, she entered into a payroll deduction and loan repayment agreement with her employer in which $341.79 would be deducted from her biweekly pay and remitted to the third-party administrator, Mutual of America Life Insurance Co.

Her first loan payment was scheduled to start on August 24, 2012. She also received a paycheck on September 7, 2012, and October 19, 2012, (after her return to work). Although her paychecks included earnings statements showing payroll deductions, Mrs. Frias never checked the detail to make sure that the loan payments were being deducted from her pay.

Upon her return to work, Mrs. Frias discovered that her employer failed to withhold and remit the loan payments. She made up for missed loan payments over a period of time and paid off the loan in full by July 9, 2014.

Here’s the law

Under IRS regulations, if a plan loan payment isn’t made on time, then the entire outstanding balance of the loan is deemed to be a distribution subject to income taxation.

However, a plan may allow a “cure period” for making the delinquent loan payment. A “cure period” could be anything from one day after the loan payment was due to the end of the calendar quarter after the calendar quarter that the loan payment was originally due.

Here’s what happened

The plan’s loan agreement had a cure period that extended to the last day of the calendar month following the calendar month that the loan payment was originally due. So the cure period for Mrs. Frias’ loan payment that was due on August 24, 2012, expired on September 30, 2012.

Unfortunately, Mrs. Frias never made her first loan payment until November 20, 2012, which was too late to prevent the entire $40,000 loan from becoming a taxable distribution.

Mutual of Omaha issued a Form 1099-R to Mrs. Frias showing a taxable distribution of $40,065 for 2012. However, the 1099-R form was issued online. Although Mrs. Frias had access to the website, she did not access or review the Form 1099-R and did not include the deemed distribution in her 2012 tax return.

On October 6, 2014, the IRS issued her a notice of deficiency for 2012, and the case ultimately went to the U.S. Tax Court.

Here’s how the problem could have been avoided

Mrs. Frias never checked the wage withholding detail that was furnished to her while she was on maternity leave. If she had, she could have discovered that the required loan payments had not been deducted from her pay.

Mrs. Frias was a professional and had prior experience with plan loans as this was not the first plan loan that she had received.

If she had discovered the error with either her August 24, 2012, or September 7, 2012, payroll checks, she should have had plenty of time to “cure” the problem by the plan’s September 30, 2012, cure date.

What would have happened if Mrs. Frias’ maternity leave had been without pay?

If Mrs. Frias’ maternity leave had been without pay, she would not have had to make any loan payments during her maternity leave. However, after she returned to work, her biweekly loan payments would have had to increase to pay off the loan by its original due date. There would have been no adverse income tax consequences.

Could things have been worse?

Yes. The IRS tried to impose a penalty against Mrs. Frias in the amount of $3,188 for substantial understatement of income tax.

Fortunately for her, the court determined that she had acted in good faith, and the penalty was not imposed.

Contact Jim Derzon at 800-236-2246 to learn more.

Jim Derzon, CPA, is an employee benefits specialist for our firm on technical matters pertaining to retirement plans and employee benefits. Jim works in these areas with our clients, large and small. He has extensive experience in both industry and public accounting.