What does deemed mean on a 401k loan?

If your employer allows 401(k) loans, you may be able to access your retirement money even before retirement. Generally, you can borrow no more than 50% of your accumulated benefits, up to $50,000. You must pay back the loan with interest over a defined period, and the loan payments are paid directly to your 401(k) account. However, if you are unable to make loan payments on time, the loan could fall into default.

A deemed distribution occurs when a participant violates certain terms of a 401(k) loan such as the loan amount, loan repayment schedule, or the loan term. For example, if there are missed loan payments by the end of the cure period, the defaulted loan is considered a deemed distribution. Although a deemed distribution is not an actual distribution, the unpaid loan balance will be reported as a taxable distribution on Form 1099-R.

What is the Cure Period?

If you have missed loan payments, the plan administrator may allow a “cure period” when you will be required to make up for the missed payment. In most cases, the cure period is the end of the calendar quarter following the quarter in which the payment was missed. For example, if you missed a payment in March, you have until the end of the next quarter i.e. June 30, to pay the missed loan payment and evade the default.

A cure period is not mandatory for 401(k) plans, and a plan can decide to have a shorter cure period or not allow a cure period. If an employer provides a cure period, it should be provided for in the plan document. The 401(k) participant must make the delinquent payment during the cure period to bring back the defaulted loan into compliance without triggering a deemed distribution. If the loan is still in default after the lapse of the cure period, the participant must make a lump sum payment to pay off the outstanding loan balance or re-amortize the outstanding loan balance.

How deemed distributions are taxed

If a 401(k) participant does not make up for the missed loan payments by the end of the cure period, the 401(k) plan will process the defaulted loan as a deemed distribution. The deemed distribution will then be treated as an actual distribution to determine your tax liability. You will receive Form 1099-R, which reports the outstanding loan balance and interest as a taxable distribution.

Usually, the outstanding loan balance will be taxed at your tax bracket rate. If you are below age 59 ½, you will pay an additional 10% tax for early withdrawal. If you leave the company, you cannot rollover the deemed distribution to another 401(k) or IRA. Instead, the outstanding balance will stay on the company’s books. 

Repaying Defaulted Loan After Deemed Distribution

If a defaulted loan is considered a deemed distribution, the unpaid loan is retained in the company’s books and it continues to accrue interest. The participant is obliged to pay off the outstanding loan balance following a deemed distribution.

The participant can pay a lump sum payment to clear the outstanding balance, plus any accumulated interests. An alternative option is to amortize the outstanding loan balance over the remaining duration of the original repayment period. A participant can also use a combination of both methods.

The unpaid loan cannot be deducted from the participant’s 401(k) balance until there is a distribution-triggering event. For example, if a participant requests a distribution, the retirement plan will offset the unpaid loan amount from the participant’s accrued benefits. The plan loan offset is treated as an actual distribution, and it may not be paid back to the retirement plan.

Deemed distribution vs. Plan Loan Offset

A deemed distribution occurs when certain loan terms are not met. For example, if a participant misses loan payments after the end of the cure period, the defaulted loan is considered to be a deemed distribution. A 401(k) loan that is deemed distributed remains outstanding until the loan obligation is satisfied, either by a lump sum cash payment or offset against the 401(k)’s accrued benefits. However, deemed distributions are not actual distributions, and hence, cannot be rolled over to another 401(k) or IRA.

In comparison, a plan loan offset occurs when a participant’s 401(k) balance is reduced to repay an outstanding loan balance. Unlike a deemed distribution, a plan loan offset is an actual distribution, and it occurs when the participant is eligible to take a distribution and request a distribution. The distribution is reported in Form 1099-R as a taxable distribution. A participant can avoid paying taxes on the distribution by rolling over the plan loan offset to a 401(k) or IRA within 60 days. If the plan loan offset is qualified, the rollover period is extended to the federal income tax due date for the year in which the distribution occurred.