The Tax Cuts and Jobs Act, Public Law 115-97 (TCJA), enacted in December 2017, made significant changes to the plan loan offset rollover eligibility and tax reporting. The changes add a significant amount of complexity to tax reporting for these loans, and as a result, the industry has been slow to implement the changes.
In August 2020, the IRS published proposed regulations that provide more detail on the requirements of the new provisions. Section 13613 of TCJA provides an extended rollover period for a qualified plan loan offset, which is a new type of plan loan offset. These regulations affect participants, beneficiaries, sponsors, and administrators of employer plans, including 403(b), QP, and governmental 457(b) plans.
In general, loans are “offset” at the point when a participant reaches a distributable event and takes a lump sum distribution from the plan. This means the loan balance is reported as a distribution that is taxable to the participant. The only opportunity to avoid the taxation on this offset was for a participant to complete an indirect rollover, depositing the amount of the offset loan balance into an IRA or another eligible retirement account with 60 days of the distribution.
Under the new regulations, there are now three different terms for a loan that is distributed, and each has rollover rules specific to it.
Qualified Plan Loan Offset (QPLO): The amount of the loan balance that is offset if it meets all of the following conditions:
- The distribution is required due to either plan termination, or the employee having separated from service and not permitted to continue to repay the loan.
- The loan is in good standing at the time of the distribution.
- Occurs within the period beginning on the date of the employee’s severance from employment and ending on the first anniversary of that date.
For tax reporting purposes, the loan is reported with a code M on the 1099-R, with either a 1 or 7 based on the age of the participant. If the QPLO is coming from a Designated Roth Account, the loan is reported with a codes M and B. If a numeric code is needed, for example a code 1, then the “M” is dropped from the reporting leaving only B1.
QPLO amounts have a rollover deadline of the participant’s tax filing deadline for the year of the distribution, plus extensions. This means the participant has an extended amount of time to accumulate funds to reduce the taxation of the offset distribution.
Plan Loan Offset (PLO): Loans that are offset, but do not meet the requirements of a QPLO, continue to be eligible for a 60-day rollover. These loans continue to be reported as a distribution with a code 1 or 7 on the 1099-R.
Deemed Distributions: Loans go into default when they fail one of the loan requirements under section 72(p) (such as borrowing too much, or not using a “reasonable interest rate”) or reach end of the cure period outlined in the plan loan policy. The loans are reported as a distribution on the 1099-R with a code L and either a 1 or 7 depending on the age of the participant. These loans remain an asset of the plan and continue to accrue interest until the participant reaches a distributable event.
Example 1: Susan separates from service in March of 2020. She has a loan balance of $5,000, which she cannot afford to pay off immediately. She rolls over the remaining balance in her account and the loan is offset. Susan’s loan was in good standing at the time of distribution, and will be reported with the code M1 on her 2020 1099-R. She has until Oct. 15, 2021 to accumulate as much possible to rollover the QPLO.
Scenario A: Susan is able to save $2,000 before Oct. 15, 2021 and deposits that amount as a rollover of her QPLO. The taxable portion of her initial $5,000 has now been reduced to $3,000.
Scenario B: Susan is able to save the full $5,000 of her loan offset and deposit it as a rollover of her QPLO before Oct. 15, 2021. She now has zero tax liability caused by the QPLO.
Example 2: Assume the same facts as Example 1, except Susan takes a partial distribution when she separates from service, as well as rolling over her remaining account balance. Susan takes a distribution of $8000. The 20% mandatory withholding on that distribution must also include the loan balance. This means $2,600 is withheld for federal income taxes and the net payment to Susan is $5,400. Her overall tax liability from the distribution is $13,000.
Susan is eligible to do a 60-day rollover of the amount she received in her distribution, plus the total amount that was withheld in federal income taxes to avoid taxation on that distribution.
Susan’s QPLO amount is still $5,000 and she has until her tax filing deadline, plus extensions to complete that rollover.
Example 3: Carolyn separates from service in July 2019. She has a $10,000 loan at the time of her separation.
Scenario A: Carolyn’s plan permits her to continue repaying her loan balance. Carolyn leaves the money in the plan and continues to repay the loan until September 2020, when she rolls over the balance in her account. The remaining balance on Carolyn’s loan is offset as part of the rollover distributions, but is not a QPLO because more than one year has passed from Carolyn’s separation from service.
Carolyn’s only rollover option related to the loan balance is a 60-day rollover. (Comment – this once again provides the dilemma of how to measure the 60 days when a loan is offset and it is not a QPLO. The regulations do not address the measurement of the 60-day period.)
Scenario B: Carolyn’s plan permits her to continue repaying her loan balance. Carolyn leaves the money in the plan and continues to repay the loan until April 2020, when she rolls over her account balance. The loan is offset when the rollover distribution occurs. Carolyn’s loan is not treated as a QPLO because Carolyn was eligible to continue repaying the loan and elected to take a distribution and offset the loan.
Questions
1. Can a participant make multiple rollover contributions as if they were repaying the loan balance? For example, can a participant deposit $500 per month until Oct. 15 as rollover contributions of the QPLO?
A. There is nothing in the proposed regulations that prevents this. Rollover distributions from employer plans are not subject to the one-rollover-per year rule, so until the IRS issues guidance saying otherwise, yes the participant can make multiple rollover deposits if the QPLO amount until their tax filing deadline plus extensions.
2. What is “good standing” for the purposes of a loan being eligible to be treated as a QPLO?
A: The loan must meet the requirements of 72(p)(2) immediately before the distributable event causing the offset. This includes:
- The loan is evidenced by an enforceable agreement;
- The loan term cannot exceed five years, unless the loan a primary residence loan and eligible for a longer term; and
- The loan must be repaid in substantially level installments.
- Additionally, at the time the loan was granted, the amount of the loan may not exceed the limits of 72(p)(2)(A).
- In general, this means the loan balance must be less than 50% of the vested balance in the participants account. If the loan exceeded these amounts then the excess would have been a “deemed” distribution at the point that the loan was made unless corrected under EPCRS.
While the proposed regulations provide for much needed tax relief for participants with loan offsets, administrative requirements tied to this relief are quite complex.
Kaitlin James, AIF®, is a Retirement Plan Consultant with Lincoln Investment.
Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.
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