IRS Releases Final Regulations on Rollovers of 401(k) Qualified Plan Loan Offsets

On December 7, 2020, the Internal Revenue Service (“IRS”) issued its final regulations addressing rollovers of qualified retirement plan (particularly 401(k) plan) loan offset amounts. Proposed regulations covering this subject were issued on August 17, 2020 (see our previous blog Proposed Regulations on Rollover of 401(k) Qualified Plan Loan Offsets – ComplianceDashboard for details). Like the proposed regulations, the final regulations reflect changes to the previous rules about rollovers of plan loan offsets made by the Tax Cuts and Jobs Act of 2017 (“TCJA”), which was signed into law by President Trump on December 22, 2017.

KEY TAKE-AWAY: The final regulations largely mirror the proposed regulations, with the notable exception of a change in effective date. Instead of applying to plan loan offset amounts treated as distributed on or after the date the final regulations are published in the Federal Register (as was provided in the proposed regulations – and which would have been December 7, 2020), the revised applicability date now generally applies to plan loan offset amounts, including “qualified plan loan offset” (“QPLO”) amounts (see below), treated as distributed on or after Jan. 1, 2021. (See “Effective Date,” below.)

Background. ERISA and the Internal Revenue Code incorporate rules permitting participants in 401(k) plans to borrow against their plan accounts (see “401(k) Participant Loans and Prohibited Transactions” for details). Among the various legal requirements are that repayments must be made equal installments in accordance with a definite schedule, and that loans must be adequately secured – usually by the remaining balance in the participant’s 401(k) account.

If a participant defaults on a loan — for example, because of missed repayments — plans typically distribute the amount of the unpaid loan balance in what is often referred to as a “loan offset.” In this situation, the participant’s accrued benefit is generally reduced by the entire amount of the outstanding loan balance, so as to repay the loan and enforce the plan’s security interest. Importantly, a loan offset counts as an actual distribution from the plan (as opposed to a “deemed distribution” which may occur under other circumstances) — which means that the entire amount of the loan offset (i.e., the entire dollar amount distributed) is normally taxable to the participant in the year in which it is received.

To avoid this immediate taxation on the amount of the loan offset, the amount generally may be “rolled over” by the affected participant into another qualified retirement plan or an individual retirement account (“IRA”). (See our article entitled “401(k) Plan Distributions and Vesting” for specifics about rollovers.) For this to work, the “loan offset rollover” normally would have to be completed by no later than 60 days following the date of distribution of the loan offset amount. But the TCJA added a narrow exception (further described below) for “qualified plan loan offsets” (“QPLOs”).

NOTE: Because a plan loan offset only extinguishes the loan liability and does not result in the receipt of actual funds, the money for a loan offset rollover must come from the participant’s other assets. In other words, cash equal to the full amount of the loan offset – regardless of where the cash comes from — must be rolled over to another qualified retirement plan or IRA within the proper time period in order to accomplish the loan offset rollover.

TCJA Added New “Qualified Plan Loan Offset” Exception. To bypass the 60-day requirement, the TCJA added a new exception for “qualified plan loan offsets” (“QPLOs”). Effective January 1, 2018, solely in the case of a loan offset distribution made due to a plan termination or a participant’s severance from employment, the deadline for making a loan offset rollover is extended until the due date, including extensions, for filing the participant’s federal income tax return for the taxable year in which the offset occurs. Notably, all other loan offset rollovers due to any other circumstances still must be completed by no later than 60 days following the date of distribution.

COMMENT: The policy behind the new exception appears to acknowledge that events such as plan terminations and severance from employment are usually beyond an employee’s control, and requiring a 60-day period in which to come up with what may be a large sum of money might impose an undue hardship.

The Final Regulations:

NOTE: This article is intended as a general overview of the final regulations and is not meant to describe all the details about plan loans or rollovers. For more information on these topics, please refer to the resources mentioned above.

As previously stated, proposed regulations under TCJA were issued on August 17, 2020. Following the customary comment period, during which the IRS received a single comment, the final regulations have followed quickly, with no substantive changes other than the change in effective date already mentioned.

To recap, the final regulations follow the proposed regulations in that they:

  • Define “qualified plan loan offset amount” as an amount that:
    • Is treated as distributed from a plan solely because of (i) the plan’s termination, or (ii) the participant’s failure to repay the loan due to a severance from employment; and
    • Relates to a plan loan that met all relevant Internal Revenue Code requirements before the plan was terminated, or before the employee’s employment was severed, as applicable.
  • Define the terms “qualified employer plan” and “severance from employment” by references to relevant, existing sections of the Internal Revenue Code and regulations.
    • Generally stated, “qualified employer plans” include tax-qualified retirement plans and IRAs, including ROTH IRAs.
    • An employee generally has a severance from employment when he or she ceases to be an employee of the employer maintaining the plan.
  • Provide that an offset (including a QPLO) is treated as being caused by a severance from employment if the offset:
    • Relates to a failure to satisfy the loan’s repayment terms; and
    • Occurs within one year of the participant’s severance from employment.
  • Provide that a QPLO amount may be rolled over to an eligible retirement plan by the due date (including extensions) for the federal income tax return for the year in which the offset occurs.
  • QPLOs are to be reported on IRS Form 1099-R.

Like the proposed regulations, the final regulations include examples that illustrate how the rules work in typical plan settings.

Effective Date. The proposed regulations would have been effective as of the date that final regulations were published in the Federal Register – which would have been December 7, 2020. However, as previously stated, the final regulations were revised to apply to plan loan offset amounts, including QPLO amounts, treated as distributed on or after Jan. 1, 2021. Taxpayers are permitted – but are not required – to apply the final regulations with respect to plan loan offset amounts, including QPLO amounts, treated as distributed on or after Aug. 20, 2020 – which was the publication date of the proposed regulations.

The information and content contained in this blog post are for general informational purposes only, and does not, and is not intended to, constitute legal advice. As always, for specific questions concerning your 401(k) retirement plan, or for help in operating your plan during the current COVID-19 crisis, please consult your own ERISA attorney or professional advisor.

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