Many of the topics I blog about are tax deductions or credits or planning opportunities – good things. A deemed distribution is something to be avoided. It is definitely not a good thing.
A deemed distribution means that even though the money wasn’t originally intended to be a distribution, rules were broken and the IRS has reclassified the money as a distribution, which is to the detriment of the taxpayer. The most common example is a loan from your 401(k).
You are allowed to take a loan from your qualified plan as long as you agree to pay it back within 5 years and make substantially equal payments on the loan. Taking the loan is not a taxable transaction, it’s just a loan. When you fail to make the payments, essentially breaking the agreement, the loan becomes a deemed distribution.
The IRS will reclassify that loan as a distribution from the qualified plan since you failed to live up to the agreement. So what exactly does that mean? It means when the loan was taken out, it is instead a taxable distribution and the early distribution penalties would apply. Making the “loan” taxable and applying a 10% penalty is obviously going to have a huge negative tax consequence.
I don’t recommend taking loans from qualified plans because that money should be set aside for retirement. The deemed distribution rules are a harsh penalty if you fail to live up to the loan agreement. That’s why money in qualified plans should absolutely be the last resort when you are in need of cash.