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I took out a 401k loan against a new home, and failed to make the payments in a timely fashion due to misunderstanding on my part and lack of address updating on the plan holder's part. My first indication that anything was wrong was after I received notification that the loan had defaulted.

After the default, our nearly useless plan administrators told me that the only remedy was to file for a VCP correction with the IRS. I gave the go ahead, and they sat on it for nearly a year. Then they came back and said I was ineligible for a VCP correction because I am a highly compensated individual.

I have tried to read the relevant IRS docs, and I can find nothing to support this. The plan administrators are stonewalling me saying that I could not possibly understand the complexities of the situation and I just need to believe them.

Are there compensation tests or other limits to who can file for a VCP correction?

  • Why were payments not withheld from pay checks? – JoeTaxpayer Jun 30 '16 at 22:14
  • No, they were not. My understanding was that this would be done automatically by my plan admins and payroll. Instead, there was paperwork for me to fill out which I did not receive because the plan did not update my address and USPS did not forward. By the time I knew, it was too late. – KCSF Jun 30 '16 at 22:29
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I'm not an expert in this; this is all speculation, but it might point you in the right direction.

My understanding is that the Voluntary Correction Program (VCP) is for 401(k) administrators to fix mistakes that they made. You can't file a VCP, but if they determine that they made a mistake that needs fixing or that they have a procedure that caused an error, they can use the VCP to fix the problem and put their plan back into compliance.

The VCP site has an example situation similar to yours. In it, the employee took a 401(k) loan, but due to a mistake by the employer, the payroll department never got informed of the loan, and no payroll deduction payments were made. The solution offered is to use the VCP to come up with a plan to fix the error, perhaps by having the participant make a lump sum payment to catch up, or by reamortizing the loan and increasing the size of the monthly payments. The solution gets approved by the IRS and then the plan is carried out.

This only works if they acknowledge that they made a mistake. If their story is that the whole thing is your fault, that you took out the loan and then refused to make a payment, their position might be that they made no mistake; in that case, it might simply be treated as an early distribution and you would owe all the tax and penalty.

Fixing this will require their cooperation. If you aren't getting it, you'll probably need to talk to an attorney that specializes in employee/employer relationships.

For anyone else reading, this is one of several reasons why it is not recommended to take a 401(k) loan. Employers are not banks and are not used to handling loans. They can mess things up, and when they do, the tax consequences can be disastrous.

  • Thanks Ben. The main problem in finding answers is because the document is so large and sprawling, and in almost all cases it is indeed aimed at plan (vs. individual) failures. However see section 6.07 here irs.gov/irb/2013-04_IRB/ar06.html#d0e1200 item 'd' which covers my situation. Filing a VCP is super complicated, and I am willing to get help, but identifying help has been a problem. My plan admins are supposed to be in my corner, but they are just awful. – KCSF Jul 1 '16 at 0:47
  • I personally disagree with your last paragraph about not taking 401(k) loans. I've taken two (which overlapped in time), re-amortized them because I was on maternity leave for several months and then paid them off early. It all worked fine. You just need to confirm that the deductions are being made, that you understand the terms (like any other loan), etc. – mkennedy Jul 1 '16 at 1:22
  • @mkennedy Yes, YMMV. Not every employer messes up the loan, and not every borrower loses their job while the loan is out, and not everyone misses the retirement gains that are lost while the loan is out. It can work, but there are a lot of things that can go wrong with a 401(k) loan. – Ben Miller Jul 1 '16 at 1:40
  • I think it's a good caution, but, yes, be careful. Don't be like me, kid. – KCSF Jul 1 '16 at 1:43
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    @BenMiller - this is an example of a bad admin and bad process. I've taken loans, and the loan wasn't disbursed until the forms were all set. I got my check, and next paycheck, the first payment was taken. No different than the articles that "401(k)s have failed us" due to 2%+ annual fees, when the fault is in the fees, not the nature of the 401(k). – JoeTaxpayer Jul 1 '16 at 12:52

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