Advanced Underwriting Consultants

Question of the Day – September 5

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question:  My client has an existing loan against her 401K account, and she recently terminated her employment.  If she takes a distribution of her 401K account balance, will the 20% mandatory withholding rule apply to the loan balance?

Answer:  Yes, unless she repays the loan prior to the distribution of the account.

Under Regulation Section 1.72(p)-1, a loan balance can give rise to two kinds of taxable distributions:

  1. A deemed distribution or
  2. A distribution of an offset amount.

A deemed distribution occurs when a plan loan fails to meet the requirements of the tax code to be a valid qualified plan loan.  Such deemed distributions are treated as taxable distributions from the plan, and are subject to ordinary income tax and the penalty tax if the participant is younger than 59 ½.  A deemed distribution is not eligible for rollover.

Since only rollover distributions are subject to 20% mandatory withholding, a deemed distributions is not subject to mandatory withholding.

A distribution of an offset amount is also taxable and subject to the penalty tax.  The most usual type of distribution of an offset amount is a loan balance that remains unsatisfied after a participant separates from service.  The unpaid loan balance is eligible for rollover if the participant replaces the funds within an IRA or other qualified plan within 60 days of the time of the offset.

Since the offset amount is eligible for rollover, it is subject to 20% mandatory withholding.

If there are insufficient funds in the 401K account to cover the mandatory withholding associated with the cash balance plus the offset amount, the regulations provide that only the available cash will be used for mandatory withholding.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.