Recap of Change to Retirement Plan Rollover Rules for Plan Loan Offsets

The Tax Cuts and Jobs Act of 2017 (“2017 Tax Act”) includes a provision that changed the rollover rules for certain plan loan offset distributions and that may not be well known to retirement plan sponsors and participants.

Money purchase, profit sharing, 401(k) and 403(b) plans may make loans available to plan participants. If a participant with an outstanding loan terminates employment and fails to repay the loan in accordance with its terms (including repayment by the end of any cure period established under the plan), the plan will reduce (offset) the terminated participant’s vested account balance by the principal and accrued interest outstanding on the loan. This means the entire outstanding loan balance will be treated as a distribution from the plan paid directly to the terminated participant, and the taxable portion of the distribution will be subject to income tax (and the 10% penalty tax for early distributions, if applicable).

Prior to the 2017 Tax Act, the participant had only sixty days after the plan loan offset distribution to roll over the amount of the plan loan offset distribution to an IRA or another employer’s eligible retirement plan to avoid the income tax consequences. The 2017 Tax Act extends the 60-day rollover window for participants whose loans are distributed in an offset distribution due to the termination of the plan or their inability to repay the loan in accordance with its terms because of their severance from employment. These participants have until the due date (including extensions) for filing their federal income tax return for the year in which the offset distribution is made to roll over the amount of the offset distribution. The extended rollover window is available for plan loan offset distributions made in tax years beginning after December 31, 2017.

Example 1: Sarah, a 30 year old employee, has a vested account balance in her employer’s 401(k) plan of $40,000, which includes a $10,000 outstanding loan. She terminates employment in January, 2019 and requests that distribution of her entire vested account balance be paid in a direct rollover to her IRA. The plan reduces (offsets) her $40,000 vested account balance by her $10,000 loan balance and then pays the $30,000 cash balance in a direct rollover to her IRA. The $10,000 plan loan offset distribution is subject to income tax and the 10% penalty tax for early distributions.

Sarah would have until April 15, 2020 (the due date of her 2019 federal income tax return, unless extended) to come up with $10,000 and roll that amount to an IRA or her new employer’s eligible retirement plan (assuming that plan accepts rollovers of qualified plan loan offset distributions). If she does this, she would avoid paying income tax and the 10% penalty tax on the $10,000 plan loan offset distribution.

Example 2: Sally, a 30 year old employee, has a vested account balance in her employer’s 401(k) plan of $40,000, which includes a $10,000 outstanding loan. She terminates employment in January, 2019 and requests that distribution of her entire vested account balance be paid directly to her. The plan reduces (offsets) her $40,000 vested account balance by her $10,000 loan balance and then pays her $22,000 (the $30,000 cash balance minus $8,000, which is the mandatory 20% federal withholding amount on $40,000) and reports a $40,000 taxable distribution on Form 1099-R. If Sally rolls over $30,000 (the $22,000 cash distribution she received plus $8,000 from other sources), the $10,000 plan loan offset distribution will still be subject to income tax and the 10% penalty tax for early distributions.

Given Sally’s election to have her entire account balance paid directly to her, she has two options to avoid paying income tax and the 10% penalty tax. Under the first option, Sally could repay her plan loan before distribution of her vested account balance is made, so that the plan would have paid her $32,000 (the entire $40,000 account balance minus $8,000, which is the mandatory 20% withholding amount on $40,000). Sally would have 60 days after receipt of the $32,000 cash distribution to roll over $40,000 (the $32,000 cash distribution she received plus $8,000 from other sources) to an IRA or her new employer’s eligible retirement plan (assuming that plan accepts rollovers). Under the second option, if Sally does not repay her plan loan before distribution of her vested account balance is made, Sally could roll over the $22,000 cash distribution she received plus $8,000 from other sources within 60 days after receipt of the cash distribution. She also would have until April 15, 2020 (the due date of her 2019 federal income tax return, unless extended) to come up with $10,000 and roll that amount to an IRA or her new employer’s eligible retirement plan (assuming that plan accepts rollovers of qualified plan loan offset distributions).

As noted above, the extended rollover window applies only to plan loan offset distributions that are qualified plan loan offsets distributions – – that is, plan loan offset distributions that occur either by reason of termination of the plan or the participant’s failure to satisfy the loan repayment terms because of his or her severance from employment. If a plan loan offset distribution occurs for any other reason, the 60-day rollover window applies.

If plan sponsors have not already done so, now is a good time to take the following actions:

1. Confirm with the plan administrator or third-party administrator that the Special Tax Notice provided to plan participants before an eligible rollover distribution is made has been updated to disclose the extended rollover window for qualified plan loan offset distributions. The IRS, in Notice 2018-74, has updated its two model notices (one for distributions that are not from a designated Roth account and one for distributions from a designated Roth account) to include language addressing the extended rollover window.
2. Decide whether the plan will accept rollover contributions consisting of qualified plan loan offset amounts. If yes, a plan amendment likely will be required because plans that accept rollover contributions typically provide that an employee must make the rollover contribution to the plan within 60 days after receipt of the distribution.

If you have any questions please contact a member of Verrill Dana’s Employee Benefits & Executive Compensation Group.