Disabled and Can’t Repay Retirement Loan

Dear Tax Talk,

I am now on a disability income and received my first Social Security disability insurance check in November 2010. Prior to this, I worked for the U.S. Postal Service from 1996 to 2009. Besides contributing to my retirement, I also contributed to a thrift savings plan. In 2008, while I was still gainfully employed, with no reason to think I would become disabled, I took out a thrift savings plan loan of about $3,500. Through paycheck deductions, I was able to successfully begin to repay my own money at a low interest rate.

My last day of work was July 2009. It was also my last period of income. Basically, my only financial support occasionally came from family members, despite being married. My wife couldn't work. It was a tough time for us between July 2009 and November 2010. Only the utility bills, food and my medical insurance co-pay obligations were met. Therefore, I was not able to repay my TSP loan. I was also cognitively unable to deal with or understand my day-to-day living situations, etc.

I received a letter from the TSP folks that my debt had been reamortized; however, the letter remained unopened for months. My wife and I had also separated around this time. By the time my wife and I reunited, the debt had been reamortized. And even though I was in a "leave without pay status" with the postal service, my TSP debt was declared as a taxable distribution. Despite having paid a significant portion of my debt while I was gainfully employed, the result was close to $5,000 in taxable distribution, a debt I believe I now owe tax on -- a penalty for early withdrawal, I believe, is what this is referred to.

I have just been made aware that the IRS has yet to receive any information from the TSP loan. This means that I probably received this notice at the beginning of 2011. I just can't recall, and the paperwork is not currently at my disposal.

In light of my health issues and everything else I've mentioned, what I wish is to have this whole debacle reconsidered; that is, to have the reamortization of my TSP debt rolled back, and then to begin to repay this loan now that I am receiving my disability income, thus, it is hoped, reversing the taxable distribution status of my unpaid loan. What rights do I have here, and basically, what steps should I take to "turn back the clock," as it were, or to turn the status of this loan back to its original status?

Long question, perhaps too much information. However, if you are willing and able, I appreciate the time and effort you will take to answer my question(s).

Sincerely,

-- Mark

Dear Mark,

I hope this answer finds you well, and I extend my sympathies.

When you fail to repay your thrift savings plan loan, the plan administrator has no choice but to declare you in default. A default in the loan repayment results in a deemed distribution. The plan administrator can allow you to cure the default, but the period for correction is short. IRS regulations state the following:

Failure to make any installment payment when due in accordance with the terms of the loan violates section 72(p)(2)(C) and, accordingly, results in a deemed distribution at the time of such failure. However, the plan administrator may allow a cure period and section 72(p)(2)(C) will not be considered to have been violated if the installment payment is made not later than the end of the cure period, which period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.

Under the scenario for declaring default, the plan administrator will treat your default as a distribution three months after failing to pay. The cure period ends at the end of the calendar quarter following the deemed distribution. So if you defaulted on the loan in July 2009, the cure period is long gone. There is no relief for disability.

Your distribution is includable in your taxable income. However, if you're on disability you would not owe the 10% penalty for early withdrawals. Complete Form 5329 and in the space provided on line 2 you would indicate you are permanently and totally disabled and thus only owe the tax and not the 10% penalty

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

Bankrate's content, including the guidance of its advice-and-expert columns and this website, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation. Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy. Please remember that your use of this website is governed by Bankrate's Terms of Use.