Defaulted Loan from a 403b plan

[AnmarieA]

My client who is a school teacher took a loan in the amount of $23K from their 403b plan in June 2022 and then left the company before the loan payments commenced via payroll deduction. The plan administrator issued the taxpayer 2 1099-Rs for this loan default in 2022, one for the amount of the withdrawn/loan from the taxpayer's 403b account for $23K which had the same amount in Box 1 and 2 on the 1099 with a distribution code of 1 (early distribution) and the second1099-R was for $23K in Box 1 and a lessor amount of $14K in Box 2 and the 1099-R had a distribution code of L (Loan default). My client is 30 years old and worked for this employer since 2016 and all his contributions were pre-tax and fully vested. No payments were ever made on the loan hence 100% of the distribution should be taxable. The plan administrator indicated that this was a special loan and that is why 2 1099-Rs were received and the $14K above the loan represented the "adjusted tax basis" which does not make sense as it relates to a 403b account. I have been corresponding with the plan administrator and they believe that the amounts are correct and will not correct the 1099-R for solely the defaulted loan amount. 

My question is why would more than 100% of the loan amount be taxable? The balance in the 403b account was transferred in 2024 to the client's new plan administrator and it did not indicate that a portion of the balance ($14K) be a non taxable future withdrawal. 

I contacted the IRS and they never heard of such a thing where a taxpayer would receive 2 1099-Rs from the same account for an amount over and above the defaulted loan amount. They indicated that the only way to fix this issue is having the plan administrator correct the 1099-R which they refuse to do. 

Can someone help shed some light on this matter or provide explanation as to why there should be an adjusted tax basis on a 403b account and in what circumstance would someone be taxed for an amount greater than the distribution from the deferred plan?

Thanks for any assistance you can provide. 

[IRonMaN]

First, make sure that your client didn't also withdraw a similar amount that would explain the 2 1099s.  If all that was "withdrawn" was the loan amount that was not paid back report the $23K as an early distribution and attach a note to the return that there was an error in reporting and the second 1099R was created in error.  But chances are, the IRS will never read the note so tell the client that he may receive a notice somewhere down the road and be prepared to deal with the issue a second time with the IRS.  But only go this route if you are 102.931879 percent positive that you are only dealing with one "distribution".

[AnmarieA]

Thanks as the client did receive a letter from the IRS indicating that the 2nd 1099-R should be included as income on the return. I reviewed the client 403b statements from inception until the account was transferred to the new plan administrator and only one loan was taken during the duration and only one withdrawal from the account for the loan in question. The IRS is telling me the plan administrator needs to correct the 1099-R and re-issue but the plan administrator is saying that the 1099-R's are correct as issued. I have never seen anything like it. I wrote a letter to the IRS stating that the one 1099-R was in error and the only taxable amount is the loan default amount with no response. In the mean while the interest and penalties are racking up for the client. The IRS recommended to pay the amount due and then once the plan administrator corrects the 1099-R then the client can file an amended return. This is a crazy solution when in fact I know that it is inaccurate. I am going to schedule a in person meeting with an IRS agent to try to resolve the situation as correspondence does not appear to be working. Thank for your response as you confirmed that my position is correct. 

[IRonMaN]

What a mess.  Hopefully things get straightened out soon.

[AnmarieA]

Finally the plan administrator corrected the 1099-R and had no taxable income amount when corrected. It has only taken me almost 3 months to obtain a corrected 1099-R!!

That resolves the first issue. Now the IRS wants to penalize the taxpayer the 10% penalty on the early withdrawal from the 403(b) account. Do hardships such as medical and educational expenses (schooling and loan repayments) qualify as an exemption from the 10% penalty similar to a 401(k) withdrawal?

Does Form 5329 handle the avoidance of a penalty for hardship exemptions for 403(b) plan withdrawals?

Since I did not file the original return for this taxpayer they are not sure how they handled the exemption from the early 10% penalty as it is not shown on the return at all.

Any feedback would be extremely helpful as I have been keeping the IRS on hold since September awaiting the corrected 1099-R and now this penalty comes alive.........

Thanks in advance for a response. 

[james2526]

Can medical or educational hardships (such as schooling or loan repayments) qualify for an exemption from the 10% early withdrawal penalty on a 403(b) plan, and can Form 5329 be used to claim this exemption?

[qbteachmt]

It's not unusual for people to confuse Hardship withdrawal provisions (which are up to the plan administrator) and IRS penalty and tax regulations. The one does not affect the other. Yes, you might allowed to take that loan for that stated purpose, which is now a distribution. No, that doesn't forgive you in the eyes of the IRS, if it's still an early distribution.

I don't understand why none of this is taxable, of course, since it was explained this was all pre-taxed. Also, this: "and it did not indicate that a portion of the balance ($14K) be a non taxable future withdrawal."

If there is no post-tax basis, there is no future nontaxable amount.

Here's the link to the IRS exceptions for the early distribution penalty:

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-o...