August 20, 2020

Proposed Regulations on Rollover of 401(k) Qualified Plan Loan Offsets

On August 17, 2020, the Internal Revenue Service (“IRS”) issued proposed regulations addressing rollovers of qualified retirement plan (particularly 401(k) plan) loan offset amounts. The proposed regulations reflect changes to the previous rules regarding 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.

Background. ERISA and the Internal Revenue Code provide rules that permit participants in 401(k) plans to borrow against their plan accounts (see “401(k) Participant Loans and Prohibited Transactions” for details). Among the numerous legal requirements are rules stating that loans must be repaid in equal payments in accordance with a defined schedule, and a stipulation that loans must be adequately secured – usually by the remaining balance in the participant’s 401(k) account.

In the event that a participant defaults on a loan — for example, due to missed repayment installments — plans typically distribute the amount of the unpaid loan balance in what is often referred to as a “loan offset.” To effectuate a loan offset, the participant’s accrued benefit is generally reduced by the entire amount of the outstanding loan balance, in order to repay the loan and enforce the plan’s security interest. Importantly, a loan offset is 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 amount distributed) is 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.) To accomplish this, the “loan offset rollover” normally must be completed by no later than 60 days following the date of distribution of the loan offset amount. TCJA, however, added a narrow exception (further described below) for “qualified plan loan offsets” (“QPLOs”).

How Does a Loan Offset Rollover Work? Because a plan loan offset only extinguishes the loan liability and does not result in a participant receiving any actual funds, the money for a loan offset rollover must come from the participant’s other assets – assuming the participant no longer has the original loan proceeds. 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 Adds New “Qualified Plan Loan Offset” Exception. To get around the 60-day requirement, the TCJA added a new exception for “qualified plan loan offsets.” 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 stemming from all other circumstances still must be completed by no later than 60 days following the date of distribution.

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

Proposed Regulations:

NOTE: This article is intended as a general overview of the proposed 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.

The preamble to the proposed regulations confirms that a qualified plan loan offset, being a subset of plan loan offsets generally, is subject to most of the existing rules relating to plan loan offsets, unless the TCJA and the proposed regulations expressly provide otherwise. The existing rules regarding plan loan offsets are generally codified in Treasury Regulations §1.402(c)-2.

More specifically, the proposed regulations:

  • 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 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 qualified plan offset 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.
    • Qualified plan loan offsets are to be reported on IRS Form 1099-R.

The proposed regulations include several helpful examples that illustrate how the rules work in typical plan settings.

Effective Date. The proposed regulations would become effective on and after the date that they are issued in the form of final regulations; however, taxpayers are permitted to rely on the proposed regulations with respect to QPLO amounts treated as distributed on or after Aug. 20, 2020.

Public Comments Solicited. The IRS welcomes comments on the proposed regulations from interested persons, submitted either in written or electronic form, and will accept them for up to 45 days after they are published in the Federal Register (in other words, until October 4, 2020). Electronic submissions must be made via the Federal eRulemaking Portal (be sure to indicate IRS and REG-116475-19). Hard copy submissions may be sent to CC:PA:LPD:PR (REG-116475-19), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington D.C. 20044.

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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