Phuong H. Phan, Docket No. 31743-21S, filed 3/6/23, failed to pick up two (count ’em, two) retirement plan distributions he got in year at issue. One he concedes, but claims he paid off the other, which was a loan from his employer’s 401(k).

Alas, no paper.

Phuong has run into a qualified plan loan offset, the loan being paid by tasking the unpaid balance from the retirement account and treating it as if paid by Phuong, with Phuong picking up the distribution as if he’d gotten cash, hence taxable. Phuong had apparently borrowed from his 401(k) before, but paid those loans back. This time, however, the 1099-R he got from the plan’s trustee showed “… in box 7, a ‘Distribution Code’ of 1M. The instructions for that form indicate the number 1 in the distribution code refers to ‘Early distribution, no known exception, (in most cases, under age 59-1/2)’ .  And the letter M refers to ‘Qualified plan loan offset’.” Transcript, at p. 6.

STJ Diana L. (“Sidewalks of New York”) Leyden explains.

“In general, a loan from a qualified employer plan gives rise to a distribution that is taxable for the year in which the loan is received. However, section 72(p)(2) provides an exception to the general rule where the loan, when adding to the outstanding balance of all other loans from the same plan, does not exceed a specified limit. See IRC section 72(p)(2)(A). Sections 72(p)(2)(B) and (C) further provide that the general rule does not apply where the loan, by its terms, must be repaid in five years from the date of its inception, or was used to finance an acquisition of a home that is a principal residence of the participant, or where the loan is subject to substantially level amortization with quarterly or more frequent payments required over the term of the loan.” Transcript, at p.7.

OK, but if the loan is not repaid per the loan documents, that’s a taxable distribution of the plan loan offset amount.

“A distribution of a plan loan offset amount can occur in a variety of circumstances, e.g. where the terms governing a plan loan require that in the event of the employee’s termination of employment or request for a distribution, the loan be repaid immediately or treated as in default. A distribution of a plan loan offset amount also occurs when under the terms of the governing plan loan, the loan is canceled, accelerated, or treated as if it were in default, e.g. when the plan treats a loan as in default upon an employee’s termination of employment or within a specified period thereafter.” Transcript, at p. 8.

“Accordingly, a distribution occurs at the time in the amount of the then-outstanding balance of the loan if the loan is defaulted, considered a qualified plan offset, or the total amount of the loan exceeds a specified amount.” Transcript, at p. 9.

Phuong must pick up the distribution, but all is not lost: IRS folds the Section 6662(a) chops.