United States

IRS issues rollover rules for qualified plan loan offset amounts

TAX ALERT  | 

Many workplace retirement plans allow participants to borrow against their account balances or accrued benefits. This is primarily a feature found in defined contribution plans such as a 401(k) plan and, while defined benefit plans can provide for participant loans they rarely do so. Even though the Internal Revenue Code imposes limits on the amount and duration of these loans, participants tend to regard plan loans as a valuable feature. The plan loan feature means some of their money is available if they need it and they would rather pay themselves back instead of the bank.

However, these loans present a problem if a participating employee terminates employment or the employer terminates the plan. In the case of a participant’s termination of employee, most plans provide that if the participant does not promptly repay the loan, the plan will offset (reduce) the participant’s account balance or accrued benefit by the unpaid portion of the loan, and the plan will treat that plan loan offset amount as an actual distribution from the plan. The unpaid balance of the loan equals the plan loan offset amount. For tax purposes, a plan loan offset amount is an actual distribution from the plan and may be eligible for rollover to another workplace retirement plan or IRA.

As a part of the law generally referred to as the Tax Cuts and Jobs Act (TCJA), Congress extended the deadline for a participant who terminates employment with an outstanding workplace retirement plan loan to rollover that loan amount. Specifically, effective Jan. 1, 2018, if the plan loan offset is due to plan termination or severance from employment, instead of the usual 60-day rollover period, a participant has until the due date, including extensions, for filing the Federal income tax return for the taxable year in which the offset occurs to rollover the offset amount. These rules apply to qualified plan loan offset amounts distributed from a qualified retirement plan, section 403(b) plan, or governmental section 457(b) plan.

Example

An employee has a $60,000 vested pretax 401(k) plan account balance. This balance includes a $10,000 outstanding loan. The employee terminates his employment on Jan. 15, 2020 and requests the plan to distribute his entire vested account balance to his IRA. In that case, the plan will reduce his $60,000 vested account balance by the $10,000 loan balance and then pay the available $50,000 to his IRA. The $10,000 loan offset amount is a distribution subject to income tax and potentially the 10% penalty tax for early distributions.

However, the employee can avoid the taxes and penalty if he rolls over $10,000 from his own pocket (the plan loan offset amount) to his IRA or another qualified plan within 60-days of receiving the distribution. Further, as noted above, for plan loan offsets occurring on or after Jan. 1, 2018, the employee has until the due date of his 2020 individual income tax return (including extensions) to come up with the $10,000 to roll over to an IRA or workplace retirement plan.

The IRS has now issued Proposed Regulation section 1.402(c)-3 that defines the difference between a plan loan offset and a qualified plan loan offset (QPLO), as well as addressing the rollover rules applicable to each type of offset transaction. 

Plan loan offset

A plan loan offset amount is the amount by which, under the plan terms governing a plan loan, an employee's account or accrued benefit is reduced (offset) in order to repay the loan. A plan loan offset is an actual distribution made on account of one of the plan’s permissible distribution events and specifically does not include a deemed distribution for failure to make scheduled payments under the loan.

QPLO defined

The proposed regulations define a QPLO as a plan loan offset amount distributed or treated as distributed from a qualified employer plan to an employee or beneficiary solely because:

  • The employer terminates the qualified employer plan, or 
  • The employee’s failure to meet the loan’s repayment terms because of the severance from employment of the employee and the offset occurs within one year of the date the employee terminated employment.

In either case, the plan loan must meet the plan loan limitations, five-year level amortization, and other requirements of IRC section 72(p)(2) immediately prior to the termination of the plan or the employee’s termination of employment. Additionally, the loan must not be in default under section 72(p) at the time of the plan termination or upon termination of employment.

The difference between a QPLO and a plan loan offset

The first two of the three following examples illustrate when a plan loan offset is or is not a QPLO. The third example considers the effect of a deemed distribution as opposed to plan loan offset distribution. 

Example 1

An employee terminates employment with a vested balance of $37,000, including an outstanding loan balance of $8,000 on June 1, 2021 and her loan was current as of the date of her termination of employment. The plan allows terminated participants 60 days after their termination of employment to repay their outstanding loans in full. She does not take advantage of that 60-day repayment option and on July 1, 2021, she receives a distribution of her account with the plan sending $29,000 to her IRA account and treating the $8,000 outstanding loan amount as being distributed as a plan loan offset. In this case, the plan loan offset is a QPLO because:

  • It is related to her termination of employment,
  • The plan loan offset occurred within one year of her termination date, and 
  • Her loan was in good standing when she terminated employment.

Because the plan loan offset is a QPLO, the employee has the extended period to complete a tax-free rollover of the offset amount (as late as Oct. 15, 2022, if she extends her 2021 individual income tax return) to another qualified plan or IRA. 

Example 2

A participant terminates employment with an outstanding loan balance of $24,000 on June 1, 2021 and his loan was current as of the date of his termination of employment. The plan allows the terminated participant to continue to make loan payments by check. The terminated participant takes advantage of that option. However, on Aug. 1, 2022, he stops making loan repayments, and the plan offsets (reduces) his account balance by the amount of the remaining loan balance of $13,000. In this case, the plan loan offset is not a QPLO because it occurred more than one year after his termination of employment, so the rollover period is not extended to the tax return due date.

However, even though it is not a QPLO, the participant may roll over up to the $13,000 plan loan offset amount to an eligible retirement plan within the normal 60-day rollover period provided in IRC section 402(c)(3)(A).

Example 3

On Feb. 1, 2020, a participant requests and receives a plan loan of $20,000. When issued the loan met the loan amount limitations, five-year level amortization period and other requirements of IRC section 72(p)(2), and repayments on the loan were current. However, after the participant made the first two scheduled quarterly installment payments, she stopped making loan payments. Accordingly, on Feb. 1, 2022, the plan deemed the loan in default under section 72(p)(1) and the plan issued her a 1099R reporting as income (on a deemed distribution basis) equal to the amount of the unpaid loan balance. Under the regulations, because the amount paid out of the plan was a deemed distribution rather than a plan loan offset, the deemed distribution is not an eligible rollover distribution.

Potential automatic extension of time to complete the rollover

The preamble to the proposed regulations notes that If a taxpayer receives a distribution of a QPLO amount and timely files his or her income tax return for the year of the distribution, the taxpayer may have an additional six months to complete a rollover of the QPLO amount (even if the taxpayer did not request an extension). Pursuant to Reg. section 301.9100-2(b), this automatic six-month extension applies if the taxpayer timely files his or her tax return by the normal due date of the return (without extensions) but then rolls over the QPLO amount within the six-month period and amends his or her return by that due date, as necessary to reflect the rollover.

Effective date

Until the IRS issues a final regulation, taxpayers may rely on the proposed regulation with respect to plan loan offset amounts, including QPLOs, distributed on or after Aug. 20, 2020 (the date it is expected to be published in the Federal Register).

Summary

These proposed regulations provide clarity as to when a retirement plan participants is eligible to rollover a plan loan amount and if eligible how much time the participant has to complete the rollover. 

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