Compliance November 17, 2004

1998 401(k) Loan Not a 'Plan Distribution'

November 17, 2004 (PLANSPONSOR.com) - A US Tax Court Judge has ruled that a loan taken from a 401(k) plan participant's account and was then never fully repaid was not a 'plan distribution' and therefore was incorrectly reported as such on the participant's tax filing.

Reported by

Kip McDaniel

>Judge Juan Vazquez ruled in favor or Isaac Molina Jr., who, after taking a loan of $20,000 from his City of Dallas-sponsored 401(k) in 1998, improperly listed it as a plan distribution in his 2000 tax filing. Molina’s employment was terminated by the city in March 1999, after which he made no further contributions to the plan, according to the unpublished opinion.

>In 2002, Molina and his wife sent the Internal Revenue Service (IRS) a compromise, arguing that the loan had been incorrectly listed as a plan distribution. After the IRS rejected the compromise, Molina filed a suit in tax court. In his ruling, Vazquez made note that under the tax code, a loan from a qualified pension plan (such as a 401k) should not be treated as a distribution if the amount does not exceed a specific limit. Also, Vazquez asserted that the loan must be repaid within five years of its inception unless it is used to finance a primary residence, and payments must be made at least in quarterly installments. The loan is considered a distribution, and is this subject to penalty taxes, if it does not meet these requirements. The final regulations of this section of the tax code, Section 72(p)(2), were not in effect at the time of the withdrawal, however, and thus do not apply to Molina’s loan, Vazquez ruled.

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>Vazquez also ruled that because Molina stopped repaying the loan after his employment was terminated, the loan no longer required repayment on a monthly basis. Thus, according to Vazquez, no distribution occurred in 2000 for Molina, and it should not have been listed on his tax filing.

The ruling, Molina v. Commissioner, T.C., No. 4026-03L, T.C. Memo. 2004-258, unpublished 11/10/04 is available at http://www.ustaxcourt.gov/InOpHistoric/mo3lina.TCM.WPD.pdf .