The vast majority of the 401 (k) plans allow participants to borrow against their plan benefits. These loans are secured by the borrower’s plan account and are usually repaid by withholding amounts from the borrower’s paychecks.
Plan Loans are subject to a number of restrictions, including a repayment period of five years (unless the loan is being used to purchase a primary residence) and a maximum credit limit of 50 percent of the borrower’s vested balance or $ 50,000. * Violation of these limits has adverse tax consequences for the borrower, which are not dealt with in this article. The focus of this article is on what happens when someone within the limits borrows a 401 (k) plan, terminates their employment, and then defaults on the loan – specifically changes brought about by Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) and an amendment to the Taxes Act of 2017 that will help the large number of people who may find themselves in this situation during the pandemic.
Plan Loan Defaults by Terminated Employees = Plan Distributions
Most 401 (k) plans require borrowers who terminate their employment prior to repayment of their plan loan to either pay the entire remaining loan amount within a period specified in the plan after termination of employment or, if not, be accounted for in Default on the loan. In this case, the tax law treats the borrower as if they had received a distribution from the plan equal to the unpaid loan. The Internal Revenue Service (“IRS”) refers to this amount as Planned offset amount.
Because plan loan equalization amounts are treated as plan distributions, the borrower will be taxed on the plan equalization amount unless an equivalent amount is deposited as a rollover to an IRA or other eligible retirement plan. As with all 401 (k) plan distributions, this rollover must occur within 60 days of the standard that caused the distribution. There are a few exceptions to the 60-day rule (which also apply to plan compensation payments), particularly the relief given in IRS Notice 2020-23 for a range of tax deadlines. According to this notice, in response to the COVID-19 pandemic, as part of Disaster Relief, the IRS extended the 60-day rollover period to July 15, 2020 for distributions made after April 1, 2020 and before May 16, 2020 were.
Employees who take out credit on their 401 (k) account and terminate their employment are often unable to repay their loan. Unless they are able to extend an amount equal to the plan adjustment amount triggered by the loan default, they will not only have to pay income tax on the plan adjustment amount, but in most cases also owe the IRS a an additional 10 percent Tax if you are not 59½ years old. In practice, there is very little relief in giving a terminated employee 60 days to avoid taxing their planning loan by extending the amount they were unable to repay. However, the CARES Act and the Tax Reduction and Employment Act (the “TCJA”) enacted in 2017 contain plenty of provisions that allow many workers whose termination of employment during the pandemic resulted in a planned loan loss and compensation having extended periods of time to roll over.
Congress to the Rescue
Coronavirus-related distributions
The CARES Act creates a new category of 401 (k) and other employer-qualified plan distributions and IRA distributions to be made on or after January 1, 2020 and before December 31, 2020 to qualified individuals (Coronavirus-related distributions). “Qualified Individuals” are individuals who are diagnosed with COVID-19, have a spouse or dependent diagnosed with COVID-19, are in financial distress, or have a spouse or member of their household due to COVID-19 has financial hardship. 19. CARES Act limits the total distributions from all eligible pension plans that an individual can treat as coronavirus-related distributions to no more than $ 100,000. Plan credit offsets that lead to plan distributions can qualify as coronavirus-related distributions.
CARES Act provides that the recipient of a coronavirus-related distribution can repay the distribution in one or more contributions to an eligible retirement plan, including IRAs and 401 (k), and three years from the day following the date the distribution is received other employer-qualified retirement plans that accept repayments of coronavirus-related distributions. The re-contributions do not have to match the plan or IRA that made the distribution. CARES law treats the refund as if it were a tax-free transfer from the plan or IRA that made the distribution to the beneficiary retirement plan. One of the complexities associated with coronavirus-related distributions is that an individual may have to file an amended tax return for the year the distribution was received if the distribution is repaid in a later year.
Under the CARES Act, if a Qualified Individual has a Plan Loan Adjustment that is a coronavirus-related distribution and the individual does not reintroduce the Plan Adjustment amount, unless the individual chooses otherwise, the person chooses income from tax returns 2020, 2021 and 2022 of the individual. However, the additional tax of 10 percent on distributions at the age of 59½ does not apply if the plan loan settlement is a distribution in connection with coronaviruses.
Qualified plan loan settlements
As part of the TCJA, Congress added an extended rollover period for what is known as the “TCJA” qualified plan loan compensation amounts. “Qualified” loan compensation amounts are plan loan compensation amounts resulting from the termination of a plan or the borrower’s failure to repay a loan as a result of an “employment settlement”.
The TCJA extends the rollover period for qualifying plan loans to the due date (including renewals) for the individual’s tax return for the year in which the offset is treated as a plan distribution. This would mean, for example, that an employee with a plan loan who ends their employment on March 1, 2021 and does not repay the entire balance of the loan by March 31, 2021 (as prescribed in the plan) has until April 15 , 2022 or October 15, 2022 if they extend their income tax return for 2021 to avoid taxing the loan through a rollover. . . A major improvement over the 60-day rollover rule, which requires rollover to be completed by May 30, 2021.
If an employee is terminated in 2020 and defaults to a 401 (k) plan loan, resulting in a plan loan settlement that is not a coronavirus-related distribution that takes place over a period of three years can be reintroduced, the employee can possibly make a rollover contribution to the plan loan compensation amount. For example, imagine an employee who ends their employment on March 1, 2020 and defaults on a 401 (k) plan loan with a balance of $ 30,000 on March 31, 2020, and then distributes the remaining 401 Employee’s (k) account in assuming the amount of USD 100,000 on August 1, 2020. Assuming the employee is a Qualified Person and the failure results in a Qualified Plan Loan Settlement, the employee could (if he so wishes) the period by avoiding taxes as follows:
- Set the $ 100.00 distribution as the coronavirus-related distribution, using the dollar amount available for such distributions, and have three years to re-contribute the $ 100,000 distribution. and
- Have until October 15, 2021 by renewing his 2020 tax return to extend the $ 30,000 loan default amount.
Recently completed IRS regulations on the interpretation of the rules for qualified plan compensation provide that a plan loan compensation amount does not count as a result of an employment severance payment unless the compensation results in a distribution within 12 months of the date of the employment severance payment. This time constraint is generally irrelevant as most 401 (k) plans require a plan loan to be repaid within a short period of time after the employment relationship has ended. However, some employers allow terminated workers to continue making loan payments after they are terminated. In these cases, loan default may occur more than 12 months after the employee’s termination of employment, especially if the plan has a standard healing period (as allowed by the IRS) until the last day of the calendar quarter following the calendar quarter in which a payment is missed . In these circumstances, the employee would only have 60 days to perform a tax-free rollover if the default in 2020 triggers a plan credit equalization distribution that is not a coronavirus-related distribution.
Where things are
CARES’s favorable treatment of coronavirus-related distributions, including loan compensation payments, will end on December 30, 2020. At the time of this writing, it is unclear whether Congress will extend this treatment. Since the pandemic is still not under control, it can be assumed that employees will continue to lose their jobs to an increased extent until the beginning of 2021 and, if they have plan loans, these loans will have to be taxed after their employment relationship has ended. In this case, without further legislative intervention, it would be possible to extend the period in order to avoid the taxation of their unpaid loans to offset the extended rollover period of the qualifying plan loan in the TCJA.
* The $ 50,000 limit has been increased by the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) to $ 100,000 for Qualified Individuals who took out a loan plan between March 27, 2020 and September 22, 2020. The CARES Act also permits plans to suspend and delay the repayment of loans from Qualified Persons for a year beginning March 27, 2020 and ending December 31, 2020 if the loan is outstanding on March 27, 2020. See the discussion in this post for the description of who a qualified person is.