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Plan Loans Have Become More Complicated Because of New Rules

By February 25, 2021No Comments

Plan loans to participants in 401k plans and other tax-qualified retirement plans require extraordinary actions by the employer to ensure compliance with (1) plan documentation requirements, (2) maximum loan amount limits, (3) strict loan repayment conditions and complicated rules if payments are missed, and (4) special tax reporting if there is a loan default or upon termination of participation in the plan.  These rules have become more complicated because of a change in law effective for 2018 and related IRS regulations recently announced, which are effective this year.

If a plan participant with an outstanding plan loan terminates employment or for some other reason has a loan default because repayments cease, and the outstanding balance is not immediately repaid in full, there typically is a “tax event”.  In other words, the loan balance will be reportable to the participant on IRS Form 1099-R as if a taxable distribution of the loan balance was paid to the participant.

Immediate repayment of the defaulted loan infrequently occurs.  Instead, if the default is because of termination of employment, the participant likely requests a distribution of the plan account balance soon after the default.  In this circumstance, the plan account is reduced by the loan balance – this is known as a plan loan offset – and the remaining account balance is paid to the participant or rolled over to an IRA or another employer’s retirement plan.

There is a way for the participant to avoid having to include the plan loan offset as taxable income on the personal income tax return – and avoid having to pay taxes or reduce the amount of any tax refund.  However, it requires the participant to come up with funds equal to some or all of the plan loan offset amount.  If there is a plan loan offset, the participant may make a contribution to an IRA (or another plan), and treat it as a rollover of the plan loan offset amount.

Before the law changed in 2018, if the participant’s loan offset was in connection with a plan distribution following termination of employment, the participant had 60 days following the plan loan offset to roll over the amount of the loan offset.  As such, participants infrequently took advantage of this rollover rule.  In many cases, the participant did not fully understand this option until after this short time period expired.

Since 2018, this special rollover may be done as late as the participant’s Federal tax filing deadline, including extensions, for the tax year of the loan offset.  For example, for a termination of employment and loan offset in 2021, the participant may make a rollover contribution to an IRA by his or her extended Federal tax filing deadline of October 15, 2022.

If the participant does not have enough cash to cover the full amount of the plan loan offset, a partial rollover can occur to reduce the part of the loan balance that will be taxable income.  Furthermore, the rollover contribution does not have to be a single deposit, but may be a series of rollover contributions completed by the extended deadline.

To further complicate things, the recent IRS regulations provide special rules regarding how long, after termination of employment, the plan loan offset can occur and be eligible for the extended rollover time.  Generally, the special rollover period only applies to plan loan offsets within 12 months of the termination of employment.  If this timing is not met, the 60-day rollover period applies.  Therefore, the IRS now has an additional set of rules for Form 1099-R reporting regarding plan loan offsets, beginning in 2022.

ACSI (www.acsi-ny.com or mbrand@acsi-ny.com) is available to discuss how the plan loan offset and rollover rules apply to your Plan.