By Angela Juvelis, CPA, Senior Audit Manager
Many employer-sponsored 401(k) plans allow for participants to borrow against their vested account balance as a “loan to participant.” Loans to participants are legally enforceable agreements, which also carry tax ramifications when repayment is not adhered to per the Internal Revenue Code and plan rules. Passage of the Tax Cuts and Jobs Act of 2017 (the Act) established a change which relates to the treatment of 401(k) loans to individuals. This change considerably increases the amount of time participants will have to fund an eligible retirement plan to avoid paying taxes on a deemed distribution due to an outstanding loan.
Prior to passage of the Act, if a 401(k) plan participant had an outstanding loan and terminated employment, depending on the plan’s rules, the loan repayment was accelerated and there were usually three options to satisfy the loan. The participant could:
- Repay the loan in its entirety.
- Cease making loan repayments. At this point, the outstanding loan balance would be deemed a distribution. The participant would be taxed as if a distribution had occurred and would receive a Form 1099-R, “Distributions from Pensions, Annuities, etc.” If the participant was under age 55, the distribution would also be subject to a 10% early withdrawal penalty. Separation from service would be an exception to the rule which assesses a 10% early withdrawal tax on a distribution to a participant under the age of 59 ½. Under this option, this deemed distribution would not be eligible for rollover into another retirement plan.
- Fund the outstanding loan balance amount and roll it over into an eligible retirement plan within 60 days.
As part of the Act, options 1 and 2 continue to be available as is; however, there is a modification to option 3. For participant loans that originated after December 31, 2017, rather than having only 60 days to rollover the unpaid loan balance, the time period will now be extended. An individual will have until the due date of their federal tax return, including extensions, for the year the loan offset occurred to contribute the amount of the unpaid loan balance to an eligible retirement plan.
Prior to this change, if a participant terminated employment on May 1, 2018 and had an outstanding loan balance of $5,000, which was offset against their account, they would have until June 29, 2018 to contribute $5,000 into an eligible retirement plan. Otherwise, this would be considered a deemed distribution. Under the new rules, if a participant terminates employment on May 1, 2018 and has an outstanding loan balance of $5,000, that originated after December 31, 2017, they will have until October 15, 2019 to contribute $5,000 to an eligible retirement plan. This is only the case though if they are a calendar year income tax filer and their 2018 tax return is on extension.
The above is good news, as it adds significant time for a participant to contribute to an eligible retirement plan and avoid tax consequences of a loan being deemed distributed. As we move through 2018, there will be a number of changes that must be addressed as a result of the Act. At Buchbinder, we are dedicated to helping you stay on course. Our partners and staff are experts at simplifying the overcomplicated. We are readily available to assess your needs and answer any questions that you may have.