Expert: Allen - 2/12/2008

Question
Allen,  I had a loan from my 401k from my previous employer, when I left the company I called the administrator to see if I could continue payments I was told this is not part of plan provisions and I needed to pay the loan in full or it would default.  I was unable to pay the loan in full so told the call rep it would have to default; this was in November of 2000.  The loan never defaulted, each year I thought I would receive something but never did until January 2008.  I have now received a 1099 for the defaulting loan, my question is this - since I left they company I have not received anything on the loan providing me with options, now the 1099 shows I received a distribution (no problem with that) the loan balance was roughly $7200, the distribution on the 1099 is for $11,400, roughly $4200 added for back interest.  The plan provisions the interest would have been paid back to me.  I have been told that the default feature was turned off in the system and they just found it last year, is it accurate that I have to pay taxes and penalty on money I never received?   I ask them why they never sent me anything on this before now and was told the responsibility was on me to contact them, which I did when I left the company.  Thanks

Answer
It is my understanding of the rules that the loan defaulted in 2000 and the $7,200 principle should have been reported as taxable income for 2001. (Under the rules it bacame taxable at the end of the second calendar quarter after you stopped making payments. Since you stopped making payments in November 2000, the end of the second calendar quarter is 3/31/01.) For the trustee to report this as a 2007 distribution is wrong.

Unfortunately, you are in a difficult situation since the IRS will be looking for taxes on the income that was supposedly received in 2007. I would write the plan administrator and tell them to issue a corrected form for 2007 showing no distribution.

If they refuse to do anything, there are only a few courses of action available to you.
1.You can contact the local office of the U.S. Dept. of Labor - Employee Benefits & Security Administration. They may be able to help you. However the Dept. of Labor will move slowly.
2. You can hire an attorney. However this may be costly.
3. You can pay the tax.
4. You can wait for the IRS to write you and ask why you didn't pay the tax. You can then explain that the income was technically received in 2001 and not 2007. The IRS may then ask for payment of the tax that should have been paid by 4/15/02 plus interest and penalties. Or they may not because the statute of limitations for payment of 2001 tax has probably expired.

Regarding your statement as to why you have to pay taxes on money you never received. You did receive the money at the time you borrowed it and it became taxable when you didn't pay back the loan. However you should not pay tax on the $4,200 in interest.

Good luck.