Jan Berger, JD
As a result of widespread job loss during the coronavirus pandemic, many suddenly unemployed people who have plunged into retirement accounts are saddled with outstanding loans from company savings plans. Counselors can play a valuable role in helping these clients by understanding how “loan offset” rules work, how CARES affects loans, and how offsetting differs from “contingent payments”.
For simplicity, this article uses the term “401 (k) loan,” but 403 (b) and 457 (b) plans may also offer loans. Although planned loans are widely available, they do not need to be offered. Please note that IRA holders, including SEP and SIMPLE IRA holders, are not allowed to borrow from their accounts.
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The IRS Code imposes several restrictions on 401 (k) loans. First, they are usually capped at 50% of the member’s guaranteed account balance, but no more than $ 50,000 (net of previous outstanding loans). The CARES Act, which came into force on March 27, 2020, allows people affected by the coronavirus to take loans taken before September 23, 2020 up to a double maximum.
Second, 401 (k) loans usually have to be repaid within five years (excluding loans used to purchase a primary home).
Third, loans must be paid in installments at least once a quarter. Most plans satisfy this requirement by requiring repayment through payroll deductions. (The CARES Act also allowed plans to temporarily suspend loan payments between March 27, 2020 and December 31, 2020 for those affected by Covid.)
Pros and cons
Scheduled loans have certain advantages over “regular” loans from a financial institution. The loan plan does not require a credit check and the application process is relatively straightforward. They offer competitive interest rates and the borrower pays himself. Finally, a loan that meets the requirements of the tax code mentioned above is not tax deductible.
But there are also disadvantages. Borrowing from 401 (k) funds temporarily deprives these assets of investment growth opportunities, causing a possible depletion of retirement savings. And, especially in these challenging economic times, borrowers risk serious tax consequences if they quit their jobs – voluntarily or voluntarily. For this reason, a 401 (k) loan is likely to be a last resort for clients in dire need of quick cash in the absence of other liquid assets available.
When a borrower quits his job
What happens when someone quits because of an unpaid loan? Many plans give the person a period to fully pay off the loan. If it does not, the plan will reduce the member’s account balance to recover the dollar amount owed. This is called “loan offset”.
Although the offset person receives virtually nothing, the offset amount is considered a distribution that is potentially taxable and a 10% early distribution penalty if the borrower is under 59½ years of age. However, customers who have the resources to reimburse the loan compensation amount can avoid paying taxes and penalties by transferring that amount to an IRA or another company’s plan.
The deadline for such a rollover was the same 60-day period as for other rollovers. However, the Tax Cuts and Employment Act extended the rollover deadline for “credit offsets under the plan” starting in 2018. (A “qualified” test is one that occurs over a 12-month period. dismissal from work or in connection with the termination of the plan.). The new deadline is the deadline for filing the borrower’s tax return, including renewals, for the offset year — usually October 15 of the following year. The IRS said the October 15 deadline is available even if an individual does not request an extension to file their tax return.
For example, 50-year-old Mia quit her job on May 15, 2020 with $ 75,000 in her 401 (k), including a loan balance of $ 30,000. Mia was unable to repay the loan. She opted for an outright rollover of her 401 (k) funds to the IRA. On June 30, 2020, the plan set off a $ 30,000 loan and transferred $ 45,000 to its IRA. Mia included $ 30,000 taxable income and $ 3,000 early distribution penalty on her 2020 federal tax return. She has until October 15, 2021 to receive $ 30,000 and make an extension. If she does, she can file an amended 2020 tax return to recover taxes and penalties paid on the offset of the loan.
How distributions related to coronavirus work
The CARES Act allowed those affected by Covid to view the company’s 2020 plan and IRA allocations of up to $ 100,000 as a coronavirus-related spread (CRD) and be eligible for three tax breaks:
- CRD is exempt from the 10% early distribution penalty.
- The taxable income of the CRD can be evenly distributed for 2020, 2021 and 2022 tax years.
- The CRD can be redeemed through a tax-free rollover within three years.
A 401 (k) credit offset received in 2020 by a Covid-affected person can be considered a CRD if the total of the credit offset and other 2020 CRDs does not exceed $ 100,000. Like the CRD, the compensation is eligible for three tax credits, including an extended renewal period.
The “estimated allocation” is different from the credit offset. This happens when someone who is still working has a loan that violates one of the 401 (k) loan rules discussed earlier (for example, it was too long, the repayment period was too long, or it was not repaid on time).
If a maturity is missed, the plan may (but is not required to) provide a period of correction until the results of the intended distribution. This period may last until the last day of the calendar quarter following the quarter in which the payment was originally due. Intended distribution is taxable and subject to a 10% early distribution penalty. However, unlike a loan offset, the notional distribution is not considered a “true” distribution and therefore can’t be flipped… It also cannot be considered a CRD (and enjoy CRD tax benefits), even if the employee is affected by Covid.
For those with an outstanding 401 (k) loan, especially those who suddenly find themselves unemployed, the last thing they want to deal with is to pay tax and a penalty on that loan. Consultants who can guide beleaguered clients through IRS loan compensation and supposed allocation rules will indeed lend a helping hand.
About the Author: Ian Berger, JD, is an IRA Analyst at Ed Slott and Company, LLC with over 30 years of experience in retirement plans and IRA issues, working in both the private and public sectors. Get more information on Ed Slott and IRA Virtual 2-Day Seminar, IRA Instant Success… Also, see Slott’s Updated Book and New Book # 1 “A new time bomb for retirement savings… “Click here to receive monthly IRA updates An e-newsletter with important breaking news and trending topics in the IRA world…