How is a loan default treated?

If a loan defaults, the loan value at the time of default is taxable and reported to the employee and the IRS on Form 1099-R. 

Distribution code L is utilized for defaulted loans when there is no offset of the plan balance due to a plan distribution triggering event. If an offset happens to occur, the actual distribution is then reported as usual (i.e., according to the participant’s age), and code L would not be applicable. The following illustrates the reporting for a defaulted loan.

Phil has a cash balance plan balance consisting of $80,000 in stocks and bonds and $20,000 of outstanding loan assets for a total account balance of $100,000. Phil then defaults on his outstanding loan, which then results in a deemed distribution of $20,000. 

For the year of the default, the third-party administrator will issue a Form 1099-R showing a gross distribution of $20,000 in Box 1 and a taxable amount of $20,000 in Box 2a. The distribution code would be “L” for a loan treated as a deemed distribution without a corresponding loan offset. 

After a few years, Phil closes his business and requests a distribution of his cash balance plan account balance. At such point, the assets consist of $120,000 in cash and the $20,000 outstanding loan balance for a total balance of $140,000. 

Before the distribution, the administrator offsets the $20,000 outstanding loan amount against the $20,000 loan receivable, leaving $120,000 as the final balance valuation. The administrator then issues IRS Form 1099-R showing a gross distribution of $120,000 in Box 1 and a taxable amount of $120,000 in Box 2a.