The IRS recently proposed regulations to:
- clarify how to determine what a “qualified plan loan offset” is, and
- explain when a retirement plan participant can take advantage of the extended rollover period for such a plan loan offset.
Taxpayers may rely on the proposed regulations starting August 20, 2020.
Retirement Plan Loans May Cause Tax Headaches When Employment Ends
Many employer-sponsored retirement plans permit participants to borrow funds against their account balances. A problem can arise, however, if the participant’s employment is terminated—voluntarily or otherwise–while their loan balance is still outstanding.
If the participant does not repay the loan, the plan treats the unpaid loan balance as a plan loan offset. The plan reduces the participant’s account balance by the unpaid portion of the loan, and treats that plan loan offset as an actual distribution. That actual distribution may then be subject to income taxes, as well as a ten percent penalty for early distribution.
Solution: Contribute the Outstanding Loan Balance to Another Retirement Plan
To avoid these tax consequences, many participants effectively “repay” the outstanding loan by contributing the same amount as their plan loan offset to another workplace retirement plan or an IRA. However, these rollovers traditionally must be completed within 60 days after the plan loan offset.
The Tax Cuts and Jobs Act (TCJA) extended this deadline for a “qualified plan loan offset.” Now, some former employees have until the due date for filing their federal tax return to rollover the offset to another qualified plan.
Proposed Regs Clarify When Extended Rollover Deadline Applies
The proposed regulations aim to clarify the difference between a regular plan loan offset and a qualified plan loan offset by providing a bright line test. A qualified plan loan offset occurs when:
- An employee ceases to be an employee of the employer maintaining the plan; and
- The employee fails to meet the repayment terms of the plan loan and the offset occurs within a year of their termination from employment.
Illustration: Qualified vs. Nonqualified Loan Offset
Example. Bob has $100,000 vested balance in his 401(k), with a $20,000 loan. Bob terminates his employment on May 1, 2020. The plan permits him to repay his full loan balance in 60 days, but he does not do so. The plan rolls over $80,000 to his IRA ($100,000 balance – $20,000 loan offset) on July 1, 2020. The $20,000 is a qualified plan loan offset because 1) Bob is terminated from his position; and 2) the plan loan offset occurs within a year of that termination. Because it is a qualified plan loan offset, Bob has until April 15, 2021 to put $20,000 into his IRA from his own pocket.
Assume instead that the plan permits terminated employees to continue making loan payments after termination, and Bob makes payments on the loan until June 1, 2021, when he defaults. The offset would no longer be considered a qualified plan loan offset, because it would occur over a year after the date of Bob’s termination. Bob would only have until August 1, 2021 to contribute the outstanding balance of his loan to his IRA and avoid any adverse tax consequences.
Employees and Plan Administrators Need to Understand Qualified Loan Offsets
Given the current employment climate, it is important for employees to understand the tax consequences if their employment ends while they are repaying a retirement plan loan. Plan administrators must also be able to determine if a plan loan offset is a qualified plan loan offset so they can properly report it on Form 1099-R. These proposed regulations should help with these tasks.
By Nitasha Kadam, J.D.