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dfernandez

Deemed Distribution For Loan Payoff

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Hi all you 403b Wise Ones,

 

I'm a fee-only financial planner (so am NOT annuity-wise) with a question on behalf of a client. She missed a TSA loan payment in March, ignored subsequent correspondence from AIG SunAmerica, and so just got a letter that said they processed a deemed distribution on 5/14 from her TSA account for the loan payoff amount of $6,700, and will issue her a 1099R next year.

 

[Given that she's under 59 1/2 and it wasn't a qualifying event/hardship withdrawal, she's obviously subject to all the penalties and taxes that go with such a distribution].

 

My confusion: the letter she got says "due to the restrictions on distributions under IRC Section 403(b)(11), the current loan balance will remain outstanding and continue to accrue interest [!!!]. At which time you become entitled to a distribution an actual withdrawal will be taken from the contract value to pay off the loan."

 

Now I'm very confused. How the heck can a deemed distribution, which apparently was for the purposes of paying off a loan, NOT pay off the loan????? And is she going to find herself owing whole bunches of money on this once she does reach the point where she can legally take distributions? And if so, can we stop this before it gets so big that it takes over her life?

 

The second part of my question is, how can we avoid the penalties and taxes? I was hoping that we could treat this like a 60-day withdrawal from an IRA and simply deposit a similar amount into a rollover and avoid the penalties, but the research dept. of the National Assoc. of Tax Preparers (NATP) said no because it wasn't a withdrawal from an IRA. But I say, how's the IRS going to know? Isn't this just like bleeding an annuity by 10% a year to get out of it, and transferring the money to another plan or IRA rollover? I do that all the time for clients, and it seems to work.

 

My colleague, Scott Dauenhauer, suggested I post this question so I could get a response from all of you. I appreciate any help you can give me; I'm stumped.

 

Delia Fernandez

Fernandez Financial Advisory

delfernandez@earthlink.net

866-443-3542 toll-free

 

 

 

 

 

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A deemed distribution is not an actual distribution of cash. Instead, it only creates a taxable event.

 

AIG is correct about the restrictions created by section 403(b)(11). That section prohibits a distribution until a qualifying event occurs. It even prevents a distribution to pay off a defaulted loan. Thus, the loan must remain intact until such time that a qualifying event occurs. Moreover, the loan will continue to accrue interest, unless it is paid in cash by the client.

 

When a qualifying event does occur, the provider will then take money out of the 403(b) account to reduce the loan balance. This is called an offset distribution.

 

There are a couple of things you might try. First, the loan regulations provide for a "cure period" for missed loan repayments. The plan may allow payment up to the end of the calendar quarter following the date of the missed payment. So, if the payment was due in March, the client would have until June 30 to make the missed payment. Keep in mind, however, that this is permissive... the plan is not required to implement the cure period.

 

If the plan won't allow the missed payment to be made, there's no way to avoid the income tax and 10% penalty on the deemed distribution short of cheating on the income tax return. AIG will send a 1099R to the client and to the IRS reporting the distribution. If it's not included in income on her return, it could open the possibility of further inspection by the IRS.

 

It's also possible to repay the loan after it's deemed distributed. This will cause the interest accruals to stop increasing the loan balance. Repayment of the loan will be made with after-tax dollars and increase the client's tax basis in the contract, so at retirement, it will come out tax free.

 

Rev. Rul. 90-24 transfers may present a problem. Again, due to the restrictions on withdrawals, AIG will be prohibited from transferring that portion that's "securing" the loan. You may be able to transfer some of the account, but not all.

 

Hope this is of some help.

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