Rev. Proc. 98-67: Fixing a Retirement Loan Default

Taking a loan from a retirement plan like a 401(k) is a common financial decision, requiring a legally binding agreement to repay the borrowed amount with interest, typically through payroll deductions. However, life events or administrative errors can interrupt this process, leading to one or more missed payments. When a participant fails to make a required payment, it can jeopardize the loan’s status and trigger adverse tax outcomes if not resolved properly.

Understanding Deemed Distributions

When a retirement plan loan is not repaid according to its terms, the Internal Revenue Service (IRS) has specific rules. If a missed payment is not corrected within a specified timeframe, the loan goes into default. At this point, the entire outstanding loan balance, including accrued interest, is treated as a “deemed distribution,” meaning it is considered a taxable event even though the participant receives no new funds.

The tax implications are substantial, as the outstanding loan balance is reported as taxable income for the year the default occurs. For example, if a participant defaults on a $15,000 loan, that full amount is added to their ordinary income for that tax year. This can push the individual into a higher tax bracket.

An additional penalty often accompanies this tax liability. If the participant is under the age of 59½, the deemed distribution is typically subject to a 10% early withdrawal penalty on top of the income tax. Using the same example, the $15,000 deemed distribution would incur an additional $1,500 penalty.

Following a deemed distribution, the plan administrator issues a Form 1099-R. This form reports the taxable amount to the participant and the IRS and will typically have distribution code ‘L’ in Box 7 to signify a loan treated as a distribution. A deemed distribution does not eliminate the loan, and the legal obligation to repay it continues. Any payments made after the default are treated as after-tax contributions to the plan.

Eligibility for Loan Correction Relief

Fortunately, a loan default does not have to automatically result in a deemed distribution. The IRS provides a formal method for correcting such failures through its Employee Plans Compliance Resolution System (EPCRS), with guidance detailed in Revenue Procedure 2021-30. This program allows participants and plan sponsors to fix the error without severe tax consequences.

To be eligible for this relief, the correction program applies to loans from qualified plans like 401(k)s and 403(b)s. A requirement is that the loan must have been legally compliant when it was originated, satisfying all rules for loan amounts and repayment terms. The participant must also show an ability to correct the failure by resuming payments.

The most time-sensitive element of eligibility is the “cure period.” IRS regulations provide a window to make up for a missed payment before the loan officially defaults. This cure period extends to the last day of the calendar quarter following the quarter in which the first missed payment was due. This deadline is firm and dictates whether a simple correction is possible.

Understanding the cure period deadline is best illustrated with examples. If a participant misses a loan payment due on February 15th (first quarter), they have until June 30th (last day of the second quarter) to make up the payment. If the first missed payment was due on July 10th (third quarter), the cure period ends on December 31st. Missing this deadline means the loan defaults.

Information and Calculations for Correction

Before a corrective payment can be made, the participant and plan administrator must gather information and perform a calculation. The documents needed are the original loan agreement and the loan’s amortization schedule. The loan agreement specifies the interest rate and repayment term, while the amortization schedule details each payment’s principal and interest components.

The next step is to calculate the total amount required for the corrective payment. This is not simply the sum of the missed payments. The calculation must include all missed principal and interest payments, plus the additional interest that has accrued on those missed payments from their due date up to the date the correction is made. This “interest on interest” accounts for the earnings the plan lost.

For example, assume a participant missed three monthly payments of $250 each on a loan with a 6% annual interest rate. The calculation would involve the $750 in missed payments. Additionally, interest must be calculated on the first missed payment for three months, on the second for two months, and on the third for one month. The sum of the missed payments and this accrued interest constitutes the total corrective payment.

If the loan default was due to an employer’s error, such as a failure to initiate payroll deductions, the employer is responsible for making a corrective contribution. This contribution must cover the interest that accrued on the missed payments.

The Correction Process

Once eligibility is confirmed and the correction amount is calculated, the participant can proceed with fixing the loan failure. The first step is for the participant to make the corrective payment to the plan. This is typically done as a single lump-sum payment for the full calculated amount, including all missed payments and accrued interest.

The payment method can vary by plan but often involves a certified check or wire transfer. It is important to work directly with the plan administrator, as they must be willing to accept the correction under the EPCRS guidelines.

After the corrective payment is accepted, the loan is considered current. The participant must then resume making their regular, scheduled payments according to the original amortization schedule. The correction does not alter the future payment schedule or the loan’s original maturity date.

A successful correction means the loan is treated as if the default never occurred. Consequently, the plan administrator will not issue a Form 1099-R for the loan failure, and the participant avoids both the immediate income tax liability and the potential 10% early withdrawal penalty.