401(k) statement

Beware of Hidden Problems That May Derail Client's IRA Rollover

A recent private letter ruling underscores the importance of being aware of the status of your client’s employer-sponsored qualified retirement account 

Advisors can strengthen their client relationships, as well as maximize assets under management, by nudging clients to complete individual retirement account rollovers on time.  Awareness of retirement account activity will make that possible.  But, it can be difficult to be in the know about a client’s employer-sponsored qualified retirement plan account, especially when it comes to a deemed distribution resulting from a plan loan default.  

Spam Folder Blamed

In Private Letter Ruling 201549032 (Sept 11, 2015), the Internal Revenue Service considered and denied a request to extend the 60-day period to make a rollover of retirement plan benefits to an IRA. In that ruling, a plan distribution that led to the need to make a rollover occurred because a former employee’s loan from her 401(k) account lapsed into default.

The taxpayer’s financial institution interrupted automatic loan payments set up to service a participant’s loan from an employer-sponsored retirement plan account.  According to the participant (who requested the ruling), the financial institution stopped making the payments because of suspected fraudulent activity in the account. The plan administrator sent a number of emails to the participant, warning that the loan would go into default status if payments weren’t resumed. It sent a similar notice by mail. The participant supplied some of these communications to the IRS with her PLR request.

The loan payments stopped during July 2014. The plan administrator sent the default warning notice by letter, dated Sept. 19, 2014, saying default would occur if payment wasn’t received by Oct. 19, 2014. It also warned that, upon default, the outstanding principal balance, plus interest accrued through the date of default, would be treated as a taxable distribution. There’s no statement in the published ruling regarding when the participant received that letter. The plan administrator sent another letter on Oct. 20, 2014 notifying the participant of her default status. Finally, it sent an email on Oct. 21, 2014 with copies of all letters sent by mail.

When the loan went into default, the unpaid balance became reportable to the IRS as a taxable distribution.1  The plan sponsor accordingly issued a Form 1099-R, reporting the taxable amount.

The participant claimed all of the emails went to her spam folder, which, as a rule, she never checks.  She claimed that receipt of the Form 1099-R long after the rollover period ended was the first she knew of the deemed distribution’s existence. The participant had funds available to effect an IRA rollover “at all relevant times.”

The IRS acknowledged that the taxable distribution arising from the plan default could have been rolled over to an IRA within 60 days. But, no rollover attempt occurred within the permitted 60-day rollover period.

The taxpayer asked the IRS to extend the rollover period for reasonable cause, as permitted under Internal Revenue Code Section 402(c)(3)(B). The IRS advised that the rollover period could be extended when the failure to waive such requirement would be against equity or good conscience, including casualty, disaster or other events beyond the reasonable control of the individual subject to such requirement. 2

When considering such a request, the IRS takes into account all relevant circumstances, including: (1) errors committed by a financial institution; (2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error; (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and (4) the time elapsed since the distribution occurred.

The IRS denied the request for extension of time to make a rollover. Pointing to the numerous notices actually received by the participant, the IRS said none of the enumerated circumstances was present.

Misled by Plan Administrator

The IRS’ decision in PLR 201549032, in which the plan participant’s failure to act on notices actually received led the IRS to deny relief, stands in contrast to its decision in PLR 201224046, in which relief was granted because of the plan administrator’s actions.  The taxpayer was misled into believing the loan wasn’t in default, even though it was.

In PLR 201224046, the taxpayer requesting relief was an employee-participant in a qualified 401(k) plan. He’d taken out a loan from that plan.

The promissory note contained a provision describing what would constitute default. If default occurred, the outstanding loan amount would be offset against his 401(k) account balance and would be treated as a distribution subject to applicable taxes and penalties. 

The loan would be in default following termination of employment if the full amount of any payment wasn’t paid by the end of the calendar quarter immediately following the quarter in which such payment was due, unless the participant, within that time, set up automatic withdrawals to make regular monthly loan payments.

Employment evidently terminated March 23, 2009, which made June 30, 2009 the end of the calendar quarter in which full payment was due by reason of terminating employment. Sept. 30, 2009, the end of the following calendar quarter, was thus the final date for either full repayment or establishing and starting monthly payments. Furthermore, the plan administrator assured the taxpayer payments could begin by that date.

The participant decided to set up monthly payments, even though he possessed at all times enough cash on hand to pay the loan in full. The plan administrator sent three letters to the participant, but he didn’t receive any of them.  The participant grew concerned and contacted the plan administrator during August 2009. The plan administrator said the 90-day period for starting automatic payments would be restarted, but didn’t state the now extended due date. Presuming the restart date was the day of their conversation and applying the loan terms regarding default to the restart date, the participant now understood his new default date to be March 31, 2010.

Because a critical suffix number was missing from the payee account number he’d received from the plan administrator, the participant’s attempt to effect automatic payments failed. A subsequent phone call with the plan administrator resulted in advice that another six weeks was available to start the payments without causing default.  The participant believed the extensions of time to start the payments were modifications of the loan terms.

Finally, on Oct. 15, 2009 payments began.

When the time came to prepare his 2009 income taxes, the participant gathered information needed for his upcoming meeting with his tax preparer. It was then that he noticed he’d received a Form 1099-R reporting the amount of his loan balance as taxable income. When he called the plan administrator, he was told that treatment of the loan balance as a taxable distribution was required by the terms of the loan. In other words, no grants of extension to start the loan payments had been recognized.

Because the plan administrator misled the taxpayer regarding extensions of time to meet the time for instating loan payments, the IRS granted a waiver of the 60-day rollover requirement with respect to the amount treated as distributed.

Safety Net

Advisors can help divert disaster by facilitating establishment of automatic loan payments from funds under management. Regular reviews of activity from the paying account could reveal any interruption of the loan payments, allowing intervention to encourage a timely rollover, if needed.

 

Endnotes

1. Treasury Regulations Section 1.72(p)-1, Q&A-3.

2. Revenue Procedure 2003-16.

 

 

 

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