Bamboozled May 7, 2019: In a blunder, N.J. forgot to collect payments on state worker pension loans. Now it wants the money back.

The state neglected to take pension loan payments from 698 state workers. (Pixabay.com)

The state neglected to take pension loan payments from 698 state workers. (Pixabay.com)

In late 2015 and early 2016, hundreds of retired state workers got surprising news.

Retirement plan loans they had taken – some more than a decade earlier, while they were still employed – were never paid in full.

The 698 retirees would have to pay up now.

The expensive mishap almost cost the pension system $7,825,000, and it’s costing some of the retirees a decade or more of extra interest.

The blunder was discovered through reviews of individual members’ accounts, which revealed irregularities with the repayment of pension loans, said Will Skaggs, spokesman for the state’s Treasury Department.

Though the state failed in its responsibility to notify the retirees that the loans were outstanding, it remains the responsibility of the retirees to pay back the money they knew they had borrowed.

Skaggs said the retirees are required to pay at least the same monthly payments that were deducted during employment until the accounts are made whole, and their interest rates are the same as when the loans were initiated.


What went wrong?

Based on IRS rules, retirement plan loans are repaid through payroll deduction and must be repaid within five years or upon separation of service.

Several errors stopped that from happening for these 698 retirees, the state said.

First, there were “manual processing errors and computer programming limitations that resulted in the state not identifying loan deductions in certain situations, particularly when employees took loans just before their retirement,” Skaggs said.

There were also employees who separated from service prior to making any payments on their loans.

Loan payoffs are calculated based on the expected retirement date noted on the loan application, Skaggs said, and the process assumes payroll deductions will continue through an employee’s final paycheck. But some employees retired earlier than they indicated on their loan applications, leaving a gap in payments, he said.

“When issues in state-administered retirement systems are identified that are not consistent with the Internal Revenue Code, the state is obligated to correct them,” Skaggs said. “Failure to do so would put the retirement system at risk of being disqualified and carry tax consequences for all participants.”


An irregular notification

That’s where a big question comes in.

Retirement plan loans that are not repaid are considered a distribution. A 1099 is supposed to be issued to the borrower, which would result in taxes due and a 10 percent penalty for borrowers who are younger than age 59 1/2.

We asked the state why it didn’t issue 1099s to the retirees when the errors were discovered. It said the state didn’t have that option “for retirees in closed tax years.”

The Treasury spokesman said the IRS will only accept corrections to taxpayer filings for a three-year period. The majority of cases were longer than three years old, he said.

That leaves some questions unanswered.

When an employee who takes a retirement plan loan leaves service, the employer is supposed to notify the employee before the loan goes into default, said Scott Feit, co-owner of Prime Pensions, a defined contribution plan administrator in Florham Park.

Based on tax law at the time, employees would have had 60 days to pay off the loans before they went into default, Feit said.

Feit said the state’s administrator failed in its responsibilities to notify the borrowers and should have given retirees the option of a 1099.

“If the state made the mistake and they failed to notify the participants and there is additional interest, the participants are being penalized,” Feit said. “I would think the state should step in and come up with some kind of remedy so the participant is not worse off.”

But that’s not going to happen.

When asked if the additional interest beyond the original loan interest could be waived because it was a state error, Skaggs said no.

“The pension fund was deprived of these funds plus interest over the years, so the interest has to be collected for system to be made whole with the IRS,” he said.

It seems the borrowers have little recourse.

There is an appeals process, Skaggs said, and the process is still ongoing.***

“Many of the appeals have already been reviewed by the various Boards of Trustees, which made the same determination that the interest could not be waived,” Skaggs said.

Many of the retirees have already repaid the amounts in full, he said, noting that steps have been taken to prevent similar issues in the future.

*** This post was updated to reflect the current state of the appeals process.

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