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Tax Treatment of Defaulted Loans

Q. You have a client with defaulted loans on a fixed annuity. He has been told that when he takes a full distribution, the defaulted loan and the accrued interest will be reportable as a taxable distribution. He was already sent a Form 1099 in the years he defaulted on the loans. Is it correct that he would, in effect, pay taxes twice on the amount of the defaulted loans.

A. That is not correct! When a participant defaults on a loan, a Form 1099R is issued with a Code ìL.î This indicates that this amount cannot be rolled over and they must include that amount in their income that year.

After default, there are three reasons why the loan would still need to accrue interest:

  1. Knowing the value of the loan if they should want to take a second loan. The highest outstanding value of the loan within the 12-month period (this includes the accrued interest) would reduce the $50,000 maximum loan amount to determine what the amount of the second loan could be.
  2. For purposes of reporting on the Form 5500 (Only for ERISA plans)
  3. If the participant wishes to pay back the defaulted loan (this would be with after-tax money since they already were taxed on the defaulted loan).

Once they have a distributable event, the loan note then ìgoes awayî and is neither reported again as part of a distribution, nor is it included in income a second time.