Qualified Plan Loan ‘offsets’ vs ‘Deemed Distributions’ and the CARES Act

Take-Away: With many individuals losing their jobs due to COVID-19, adding to their personal problems is the impact of that loss of employment on any outstanding loans that they may have taken from their qualified retirement plan account . Their failure to repay the loan will result in a taxable deemed distribution.

Background: As we have covered in the past, loans are not permitted to be taken from an IRA (traditional, SEP or SIMPLE). However, a loan can be taken from a qualified plan (401(k), 403(b) or 457(b)) but only if loans are permitted by the qualified plan document. In normal situations the loan is limited to 50% of the participant’s vested account balance, but no more than $50,000. The CARES Act double those limitations, but only for 2020, e.g. a loan of 100% of the participant’s vested account balance is authorized, but not more than $100,000, and again, only if the plan sponsor agrees to this expansion of plan loans.

Loan Duration: Historically plan loans must be paid within 5 years, in level installments, usually in calendar quarter payments. The payment is often through a payroll deduction. The CARES Act allows a qualified plan to delay loan repayments between March 27, 2020 and December 31, 2020 for up to one year. If that is the case, then future repayments of the loan will be adjusted to reflect that repayment delay.
Balancing Act: While taking a plan loan is much more simple than applying for a commercial loan from a third-party, e.g. no credit check and an easier application process, balanced against that simplicity and ease of access is the loss of tax-deferred retirement savings while the loan balance is outstanding. In addition, also to be weighed is the risk that the loan will remain unpaid because the participant lost his or her job.

Loan Offset: If a plan participant terminates his or her employment, most qualified plans that permit loans will allow a period of time for the loan to be fully repaid by the former participant. If the former participant does not repay the loan balance within that period of time, the plan will reduce, or offset, the participant’s account balance to recoup the amount of the loan that remains outstanding. If an offset occurs, the former participant will still be treated as having received a distribution from the qualified plan, and if that former participant is under the age 59 ½, he or she will also be subject to the 10% early distribution penalty.

Rollover: The immediate taxation and early distribution penalty can be avoided if the former participant uses other resources by rolling-over the offset amount to an IRA or to another qualified plan. Before a recent law change, the period of time to rollover an amount caused by a qualified plan loan offset was 60 days. The 2017 Tax Act extended that offset rollover deadline to the former participant’s federal tax return due date, including the six month extension for that return, e.g. October 15 of the following calendar year.
Example: Garrett, age 47, terminates his employment on February 15, 2020. His account balance in his former employer’s 401(k) plan is $75,000, but Garrett has a $30,000 loan outstanding from his account. Garrett thought he was moving to work for a new company, but COVID -19 hit and the new job offer was withdrawn. As such, Garrett is unable to repay the plan loan. On March 31, 2020 Garrett’s plan administrator offsets the $30,000 unpaid loan from Garrett’s account balance, leaving him with $45,000 in his 401(k) account, which remaining amount he then rolls over to an IRA. If Garrett does not timely rollover the full account balance, i.e. the $45,000 left in his account and the $30,000 that he never received, he will be subject to the 10% early distribution penalty. Come April 14, 2021, while Garrett might have moved the $45,000 into an IRA to avoid taxation, he will still have to include the $30,000 offset amount in his taxable income for 2020 and, in addition, he will have to pay the $3,000 early distribution penalty on his Form 1040 return. If funds become available to Garrett in the summer of 2021, he will be able to file an amended return prior to October 15, 2021, to recover the additional income taxes and the $3,000 penalty that he paid in April, 2021.
Coronavirus Related Distribution: There might be other relief available for terminated plan participant. Following the above example with Garrett, note that Garrett had his job offer rescinded. Accordingly, Garrett’s distribution from his 401(k) account would qualify as coronavirus related under the CARES Act. Under that Act up to $100,000 can be distributed from a qualified plan, penalty-free. Consequently, the offset amount, if coronavirus related, would be: (i) exempt from the 10% early distribution penalty; (ii) the income tax on the offset amount could be spread by Garrett over three calendar years (2020, 2021 and 2022);and (iii) in those three years until April 1, 2023 Garrett could repay the offset amount to another qualified plan or IRA, and thus recover the income taxes that he paid on the offset

Deemed Distribution: In contrast to an offset, a deemed distribution occurs when the participant-borrower violates one of the plan rules, such as borrowing more than the maximum amount allowed from his or her account, or missing a repayment obligation. Usually a qualified plan that authorizes participant loans will provide a cure period, which is often the last date of the next (following) calendar quarter when the next loan payment was due.

Four Problems with a Deemed Distribution: Four distinct problems arise when there is a deemed distribution when a plan loan goes awry:

(i) Loan Balance is Distributed: The amount of the deemed distribution is equal to the entire outstanding loan obligation, not just the payment that is missed at the time of the default;

(ii) Immediate Income Taxation and Penalty: A deemed distribution is subject to immediate income taxation and the 10% early distribution penalty;

(iii) Ineligible for a Rollover: Unlike a loan offset, a deemed distribution is not considered an actual distribution, and therefore it is not eligible for a rollover; and

(iv) Not Cast as Coronavirus-Related: A deemed distribution cannot be treated as a coronavirus related distribution, even if the participant-borrower is a CARES Act qualified individual.

Example: Caroline, age 37, borrows $40,000 from her employer’s 401(k) plan. However, the plan sponsor does not adopt the CARES Act loan repayment delay provisions. Caroline is a qualified individual under the CARES Act since her husband was diagnosed with COVID-19. The loan requires Caroline to make monthly repayments by submitting a check to the 401(k) plan administrator, with the next one due on August 31, 2020. At the time of this next loan repayment, the balance of Caroline’s outstanding loan to the qualified plan is $34,000. Caroline fails to make the payment that was due on August 31, 2020 and she fails to make any other payments due on the loan for the balance of 2020. Due to the plan’s cure period, Caroline has until December 31, 2020 in which to make up the August through December installments on her loan. If Caroline fails to make-up her missed payments by December 31, 2020, the loan balance of $34,000 will be added to Caroline’s 2020 reported income, while also subjecting her to a $3,400 penalty for the early distribution from her qualified plan. Even though Caroline is a qualified individual under the CARES Act, she cannot roll over the $34,000 and she cannot treat it as a coronavirus related distribution.

Conclusion: Millions of Americans are reeling from the economic devastation caused by the COVID-19 pandemic. For those plan participants who had plan loans outstanding, and who later lost their job or who were furloughed, causing them to miss payments on their loans, they face even more financial problems. The CARES Act and its loan extension provision can help some of those borrowers who sustain an offset, but for those who face a deemed distribution their problems are only exacerbated.