Recently the court ruled on this issue.
A teacher for a public school borrowed money from her 403(b) retirement account as a means of avoiding bankruptcy on her residence. A 403(b) account is a retirement plan (similar to a 401(k) retirement account) but only available to specific employees of public schools, tax exempt organizations, and self-employed ministers in the United States.
The teacher took out two loans of $28,899 and $4,085. Each 403(b) loan agreement stated that the loans were to be repaid in quarterly payments over five years. The loans were made in July 2010 and the teacher made the quarterly payments on time until she stopped in May 2012.
In November 2012, the creditor claimed the teacher defaulted on the loans and deemed the remaining outstanding loan balances to be taxable distributions to the teacher for 2012. For each of the loans, the creditors issued an IRS Form 1099-R entitled “Distributions from Pensions, Annuities, Retirement, Profit Sharing, IRA’s Insurance Contracts” and indicated on the 1099-R that the distribution was a deemed distribution.
A deemed distribution is a taxable distribution of the outstanding balance of a loan from a retirement account when a default occurs in the repayment of that loan. The teacher did not include the defaulted loan balances in her Federal income taxes.
The IRS caught this omission and filed suit against her. In the hearing, the Tax court ruled that the teacher had received a taxable distribution in the amount of the outstanding (unpaid) balance of the loans. The Tax Court then held the teacher owed the income tax on the outstanding loan balances, as well as, the standard 10% penalty because she had not reached the age of 59 1/2 and a 20% accuracy penalty due to the understatement of her income. Contact my law firm for more information.
Summarized from Martinez v. IRS, Tax Court (TC) Memo, 2016-182 (September 28, 2016)