As a result of widespread job loss during the coronavirus
pandemic, many suddenly-unemployed persons who dipped into retirement accounts
are saddled with outstanding loans from company savings plans. Advisers can
play a valuable role in helping these clients by understanding how the “loan
offset” rules work, how the CARES Act affects loan offsets, and how offsets
differ from “deemed distributions.”
For simplicity, this article uses the term “401(k) loan,”
but 403(b) and 457(b) plans can also offer loans. Although plan loans are
widely available, they are not required to be offered. Note that IRA owners,
including SEP and SIMPLE IRA owners, are not allowed to borrow from their
accounts.
The Rules
The IRS code imposes several limits on 401(k) loans. First,
they are normally limited to 50% of a participant’s vested account balance, but
no more than $50,000 (reduced by prior outstanding loans). The CARES Act,
signed into law in March 27, 2020, let Covid-affected individuals to borrow up
to twice the maximum for loans taken before Sept. 23, 2020.
Second, 401(k) loans must usually be repaid within five
years (except for loans used to purchase a principal residence).
Third, loans must be paid back through level installments
made at least quarterly. Most plans satisfy this requirement by requiring
repayment through payroll deductions. (The CARES Act also permitted plans to
temporarily suspend loan repayments between March 27, 2020 and Dec. 31, 2020
for Covid-affected individuals.)
The Pros and Cons
Plan loans offer definite advantages compared with “regular”
loans from a financial institution. Plan loans require no credit check, and the
application process is relatively easy. They offer competitive interest rates,
and the borrower is paying herself back. Finally, a loan that complies with the
tax code requirements mentioned above is not a taxable distribution.
But there are some drawbacks. Borrowing against 401(k) funds
temporarily removes those assets from investment growth opportunities, causing
a possible depletion in retirement savings. And, especially in these
challenging economic times, borrowers risk serious tax ramifications if they
leave employment—whether voluntarily or not. For this reason, a 401(k) loan
should probably be a last resort for clients in dire need of quick cash with no
other liquid assets available.
When a Borrower Leaves the Job
What happens when someone terminates employment with an
unpaid loan? Many plans will afford the individual a period to repay the loan
in full. If that does not occur, the plan will reduce the participant’s account
balance in order to recoup the dollars owed. This is called a “loan offset.”
While a person with a loan offset does not actually receive
anything, the offset amount is considered a distribution, potentially subject
to tax and the 10% early distribution penalty if the borrower is under age 59½.
However, clients who have the resources to replace the amount of the loan
offset can skirt tax and penalty by rolling over that amount to an IRA or
another company plan.
The deadline for such a rollover used to be the same 60-day
period applicable to other rollovers. However, the Tax Cuts and Jobs Act
extended the rollover deadline for “qualified plan loan offsets” beginning in
2018. (A “qualified” offset is one that occurs within 12 months of severance
from employment or on account of termination of the plan.). The new deadline is
the borrower’s tax return due date, including extensions, for the year of the
offset – normally October 15 of the following year. The IRS has said that the
October 15 deadline is available even if the individual does not request an
extension to file his tax return.
For example, Mia, age 50, left her job on May 15, 2020 with
$75,000 in her 401(k), including a $30,000 loan balance. Mia could not repay
the loan. She elected a direct rollover of her 401(k) funds to an IRA. On June
30, 2020, the plan did a loan offset of $30,000 and transferred $45,000 to her
IRA. Mia included $30,000 taxable income and a $3,000 early distribution
penalty on her 2020 federal tax return. She has until October 15, 2021 to come
up with the $30,000 and do a rollover. If she does, she can file an amended
2020 return to recoup the taxes and penalty paid on the loan offset.
How the Coronavirus-Related Distributions Work
The CARES Act allowed Covid-affected persons to treat up to
$100,000 of 2020 company plan and IRA distributions as a coronavirus-related
distribution (CRD) and qualify for three tax breaks:
A CRD is exempt from the 10% early distribution penalty.
Taxable CRD income can be spread ratably over tax years
2020, 2021 and 2022.
A CRD can be repaid via a tax-free rollover within three
years.
A 401(k) loan offset received in 2020 by a Covid-affected
person could be treated as a CRD, as long as the total of the loan offset and
other 2020 CRDs did not exceed $100,000. As a CRD, the offset qualifies for the
three tax breaks, including an extended period for rollover.
A “deemed distribution” is different from a loan offset. It
occurs when someone who is still working has a loan that runs afoul of one of
the 401(k) loan rules discussed earlier (e.g., it was too large, its repayment
period was too long, or it was not repaid on time).
If a repayment is missed, the plan can (but is not required
to) allow a cure period before a deemed distribution results. That period can
extend until the last day of the calendar quarter following the quarter in
which the payment was originally due. A deemed distribution is taxable and
subject to the 10% early distribution penalty. However, unlike a loan offset, a
deemed distribution is not considered a “true” distribution and therefore cannot
be rolled over. It also cannot be treated as a CRD (and enjoy the CRD tax
breaks) – even if the employee was Covid-affected.
For individuals dealing with an outstanding 401(k) loan,
especially those who suddenly find themselves unemployed, the last thing they
want to deal with is being subjected to tax and penalty on that loan. Advisers
who can guide beleaguered clients through the IRS loan offset and deemed
distribution rules will truly be “lending” a helping hand.
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