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How Advisers Can Help Clients With 401(k) Loans

IRA analyst Ian Berger explains how financial advisers can help their clients manage 401(k) loans and the tax consequences.

By Ian Berger JD

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.

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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.”

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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.

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:

  1. A CRD is exempt from the 10% early distribution penalty.
  2. Taxable CRD income can be spread ratably over tax years 2020, 2021 and 2022.
  3. 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.

About the author: Ian Berger, J.D., is an IRA Analyst with Ed Slott and Company, LLC with over 30 years of experience with retirement plan and IRA issues working in both the private and public sectors. Get more information on Ed Slott and Company’s Virtual 2-Day IRA Workshop, Instant IRA Success. Plus, See Slott’s updated and No. 1 new book, "The New Retirement Savings Time Bomb." Click here to receive Ed Slott and Co.’s monthly IRA Updates eNewsletter, featuring important breaking news and trending topics in the IRA world.