How advisors can help clients with 401(k) loans
By Ian Berger J.D.
Due to the widespread loss of jobs during the coronavirus pandemic, many suddenly unemployed who have dipped into retirement accounts are struggling with outstanding loans from company savings plans. Advisors can play a valuable role in helping these clients by understanding how “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 diet 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 against their accounts.
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The IRS code imposes several limitations on 401(k) loans. First, they are normally limited to 50% of a participant’s vested account balance, but no more than $50,000 (less any prior outstanding loans). The CARES Act, enacted on March 27, 2020, allows people affected by Covid to borrow up to twice the maximum for loans taken out before September 23, 2020.
Second, 401(k) loans generally must be repaid within five years (except for loans used to purchase a primary residence).
Third, the loans should be repaid in regular installments made at least quarterly. Most plans satisfy this requirement by requiring reimbursement through payroll deductions. (The CARES Act also authorized plans to temporarily suspend loan repayments between March 27, 2020 and December 31, 2020 for people affected by Covid.)
The pros and cons
Plan loans offer certain advantages over “regular” loans from a financial institution. Plan loans require no credit checks and the application process is relatively simple. They offer competitive interest rates and the borrower is reimbursed. Finally, a loan that meets the tax code requirements mentioned above is not a taxable distribution.
But there are some drawbacks. Borrowing against 401(k) funds temporarily removes these assets from investment growth opportunities, which can lead to a depletion of retirement savings. And, especially in these difficult economic times, borrowers risk serious tax ramifications if they leave their jobs, whether voluntarily or not. For this reason, a 401(k) loan should probably be a last resort for customers in dire need of quick cash with no other liquid assets available.
When a borrower quits his job
What happens when someone quits their job with an unpaid loan? Many plans will give the individual a period to repay the loan in full. If this does not happen, the plan will reduce the member’s account balance to recover the dollars owed. This is called “loan compensation”.
Although a person with loan compensation receives nothing, the compensation amount is considered a distribution, potentially subject to tax and the 10% early distribution penalty if the borrower is under age 59. and half. However, customers who have the resources to replace the loan offset amount can circumvent the tax and penalty by transferring that amount to an IRA or another business plan.
The deadline for such a rollover was the same 60-day period applicable to other rollovers. However, the Tax Cuts and Jobs Act extended the rollover period for “qualified plan loan offsets” from 2018. (A “qualified” clearing is a clearing that occurs within 12 months termination of employment or because of the termination of the plan.). The new deadline is the due date of the borrower’s tax return, including extensions, for the year of the compensation – normally October 15 of the following year. The IRS said the Oct. 15 deadline is available even if the individual does not request an extension to file their tax return.
For example, 50-year-old Mia quit her job on May 15, 2020 with $75,000 in her 401(k), including a loan balance of $30,000. Mia was unable to repay the loan. She chose a direct rollover of her 401(k) funds to an IRA. On June 30, 2020, the plan made a loan offset of $30,000 and transferred $45,000 to his IRA. Mia included taxable income of $30,000 and an early distribution penalty of $3,000 on her 2020 federal tax return. She has until October 15, 2021 to find the $30,000 and rollover. If she does, she can file an amended 2020 return to recover the taxes and penalty paid on the loan set-off.
The CARES Act allowed those affected by Covid to treat up to $100,000 of 2020 business plan and IRA distributions as a coronavirus-related distribution (CRD) and receive three tax breaks:
- A CRD is exempt from the 10% early distribution penalty.
- CRD taxable income can be spread pro rata over the 2020, 2021 and 2022 tax years.
- 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 does not exceed $100,000. As a CRD, the offset qualifies for all three tax breaks, including an extended rollover period.
A “deemed distribution” is different from a loan set-off. This occurs when a person who is still working has a loan that goes against one of the 401(k) loan rules discussed earlier (for example, it was too large, its repayment period was too long, or it was not reimbursed in time).
If a repayment is missed, the plan may (but need not) allow a recovery period before a deemed distribution occurs. This period may extend until the last day of the calendar quarter following that during which the payment was initially due. A deemed distribution is taxable and subject to the 10% early distribution penalty. However, unlike loan compensation, a deemed distribution is not considered a “true” distribution and therefore cannot be rolled. He also cannot be treated as a CRD (and qualify for CRD tax relief) – even if the employee was affected by Covid.
For people with an outstanding 401(k) loan, especially those who suddenly find themselves unemployed, the last thing they want to deal with is being hit with taxes and penalties on that loan. Advisors who can guide beleaguered clients through IRS loan set-off and deemed distribution rules will really “lend” a helping hand.
About the Author: Ian Berger, JD, is an IRA Analyst at Ed Slott and Company, LLC with over 30 years of experience dealing with retirement plans and IRA issues in both the private and public sectors. Get more information on Ed Slott and Company’s 2-Day Virtual IRA Workshop, Instant IRA Success. Plus, check out Slott’s new, updated #1 book, “The new retirement savings time bomb.” Click here to receive Ed Slott and Co’s Monthly. IRA Updates eNewsletter, featuring important news and hot topics in the IRA world.