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By: Hugh Bromma, CEO of The Entrust Group
IRA & 401(k) Insights
Many 401(k) plans allow participants to borrow money from their retirement plan, and this option has been useful to people put in a pinch during tough economic times. However, tapping into your retirement plan early can also have devastating financial consequences if you get laid off, and the decision to borrow from your nest egg should not be taken lightly. The case study below is taken from a real tax court case, but the names, places and dates have been changed to protect the privacy of those involved.
The Case of Joanne De Musee and Her 401(k)
Joanne De Musee began employment with ACB in 1999 and began participating in the company's 401(k) plan, administered by Investments, Inc. In late 2005, De Musee borrowed $40,958 from her plan to purchase a home. She signed a promissory note and security agreement in respect of the loan, which was governed by the terms of the plan. The loan was repayable with interest through semi-monthly payroll deductions over a 10-year term. De Musee made the scheduled payments until her employment was terminated by ACB in October 2008.
At the time of De Musse’s termination, the outstanding balance of the loan became due and payable, but she did not have the money to make any payment. Therefore, no payments were made on the loan after her termination. The loan went into default in early 2009, after the expiration of the 90-day grace, or cure, period.
In March 2009, Investments, Inc., the plan administrator for ACB, sent De Musee a letter, notifying her that she had a deemed distribution from the plan equal to the then-unpaid loan balance of $31,176.99. The letter also identified this distribution as being fully taxable and without any applicable statutory exception. In April 2009, Investments, Inc. sent De Musee a check for $61,479.94, which represented the $76,849.93 balance of her plan account less $15,369.99 in federal tax withholding. She deposited the entire $61,479.94 into her checking account, rather than depositing it into the IRA she had established with Investments, Inc.
Investments, Inc. issued a Form 1099-R, the IRS form, in which an individual reports his or her distributions from annuities, profit-sharing plans, retirement plans, IRAs, insurance contracts, etc. It reported a gross distribution to De Musee of $108,026.92 for 2009. The distribution amount reflected the gross distribution from the remainder of De Musee's 401(k) plan, as well as the unpaid balance on the loan. Although she included two other Form 1099-R distributions in her income on her 2009 federal income tax return, she did not include the distribution from Investments, Inc. The IRS determined that De Musee was required to include that distribution in income. In addition, she was subject to the additional 10 percent tax under section 72(t) on early distributions from qualified retirement plans and an additional penalty tax equal to 20 percent of the portion of the underpayment for negligence or disregard of rules or regulations.
What Happened?
The IRS Commissioner's determinations are generally presumed correct, and the taxpayer bears the burden of proving those determinations wrong. Under the IRC, or Internal Revenue Code, the burden of proof may shift from the taxpayer to the Commissioner. In this case, there is no such shift because De Musee did not allege that the burden of proof section of the IRC was applicable, nor did she establish that she fully complied with the requirements of that section.
A distribution from a qualified plan, such as De Musee's 401(k) plan, is includable in the distributee's gross income in the year of distribution. Therefore, the balance of De Musee's 401(k) plan account, $76,849.93, was disbursed in a taxable distribution to De Musee in April 2009. Accordingly, Investments, Inc. withheld $15,369.99 in federal taxes.
De Musee testified that she had intended to roll over the money she received from her 401(k) to her IRA. Generally, amounts moved from one qualified plan to another may be treated as a rollover contribution if the transaction is completed within 60 days. Regardless of her original intentions, De Musee did not take advantage of the rollover provisions, cashed the check, and spent the money. She urged the IRS to grant a waiver of the 60-day requirement and argued that Investments, Inc. made a mistake sending the check, saying they should now be willing to put the money into her IRA. Based on these facts, the IRS declined to grant the waiver.
The IRC treats loans from qualified plans as taxable distributions, though there are some exceptions to that rule. Although a loan may initially satisfy the requirements at the time that it is made, a deemed distribution may nevertheless occur because of the failure to repay the loan in accordance with the loan agreement. If a default occurs, a distribution is deemed to occur at that time in the amount of the then-outstanding balance of the loan. It is clear that De Musee defaulted on her loan and thus had a deemed distribution from her 401(k) plan account, however the issue here is the date on which the default—and thus the deemed distribution—occurred.
De Musee argued that the missed installment payment took place in October 2008 because the entire loan balance became due and payable upon her termination, pursuant to an acceleration clause in the plan documents. She argued that any distribution, therefore, took place in 2008. It is true that it was in October 2008 when De Musee first missed her payment, however, the plan documentation shows that the plan had a 90-day grace, or cure, period. The plan documents explain: “The Plan Administrator shall treat a loan in default if any scheduled repayment remains unpaid more than 90 days.” Therefore, De Musee's default under the plan did not occur until the expiration of the cure period in 2009.
Although De Musee urged the IRS to adopt her argument that the default occurred immediately upon her termination of employment, a far more reasonable interpretation is that the acceleration clause merely controls the amount due at termination (i.e., the entire balance of the loan becomes due and payable) and does not negate the 90-day cure period. Further, her own actions belie her argument that she believed the deemed distribution occurred in 2008, as she did not report the deemed distribution on her federal income tax return. The record demonstrates that the balance due at the time of the default—the date at which cure was no longer possible—was $31,176.99. Thus a $31,176.99 distribution is deemed to have been made in 2009.
The IRC imposes an additional 10 percent tax on a distribution from a qualified retirement plan made prior to a taxpayer turning 59½. There are some exceptions to this rule, but this additional tax is intended to discourage premature distributions from retirement plans. De Musee had not yet attained the age of 59½ at the time of the distributions, nor did any of the other statutory exceptions to the additional tax apply.
De Musee did not argue that any statutory exception applied, her only argument as to why she should not be subject to the additional tax is that Investments, Inc. made a mistake in failing to roll over the money into her IRA. Alleged mistakes of this sort are not among the enumerated exceptions to the additional tax. The IRC imposes a tax equal to 20 percent of any underpayment that is attributable to either negligence or disregard of rules or regulations. The term “negligence” includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws. The term “disregard” includes any careless, reckless, or intentional disregard. The IRC determined that De Musee is liable for this penalty.
The Commissioner has the burden of production with respect to a taxpayer's liability for any penalty. To meet this burden, the Commissioner must produce sufficient evidence indicating that it is appropriate to impose the penalty. Once the Commissioner meets the burden of production, the taxpayer must come forward with persuasive evidence that the Commissioner's determination is incorrect. The Commissioner satisfied his burden because the record clearly demonstrates that De Musee failed to include her 401(k) plan distributions in her gross income despite being required to do so.
The IRC provides an exception to the imposition of an accuracy-related penalty if the taxpayer establishes that there was reasonable cause for the understatement and that the taxpayer acted in good faith with respect to that portion. The taxpayer bears the burden of proving that he or she acted with reasonable cause and in good faith. The determination of whether a taxpayer acted with reasonable cause and good faith is made on a case-by-case basis. Generally, the most important factor is the extent of the taxpayer's effort to assess the proper tax liability for such year. De Musee claims that she relied on the Investments, Inc. representative's assertion that the distribution was not taxable and thus should not be held responsible for the penalty. Good faith reliance on professional advice concerning tax laws may be a defense to the negligence penalty. However, reliance on professional advice, standing alone, is not an absolute defense to negligence, but rather a factor to be considered.
De Musee did not have reasonable cause to believe that the $108,026.92 distribution they received from her 401(k) plan account was not taxable. In fact, De Musee received three 1099-R forms that year, and the IRS was not persuaded by her allegation that she believed this distribution alone was not taxable. Further, it was not reasonable for her to rely on an Investments, Inc. call-center representative for tax advice.
By Hugh Bromma, CEO of the Entrust Group
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