Plan Loans: What Happens When Employees Leave?
By Jeff Aga, QKA, QPA, CPC, TGPC, CISP, CHSP
My client had a loan in her former employer’s 401(k) plan. She just left to take a new job, but she can’t pay off the loan right now. What can she do?
Plan loan administration can be complicated, but let’s try to make it a bit easier for your client. First of all, most plans will not permit former employees to continue regular loan payments—since repayment through the former employer’s payroll system is normally required. So if you’re not working there, you cannot use payroll deduction. The plan could accept a lump sum payoff of the loan, but this doesn’t happen very often. The client then has a choice: she can leave her assets in the plan or she can request a distribution. If she does nothing, the loan will be considered in default once payments stop. If the loan isn’t repaid within the “cure” period—which ends after the calendar quarter following the quarter in which the default occurs—the former employer will typically treat the loan as a “deemed distribution.” This means that the plan administrator will generate an IRS Form 1099-R with a code “L.” This tells the IRS that the loan is taxable in that tax year and that the loan amount cannot be rolled over to an IRA or another plan.
So what about the second option?
She can request a distribution. Assuming that the loan was in good standing when she left and that she takes the distribution within 12 months of leaving, your client now has more time to “repay” the loan (or even a portion of it) into an IRA. Here’s what’s changed: about two years ago, the IRS released final regulations on qualified plan loan offsets, or QPLOs. (That’s what we’re talking about here.) And since 2021, these new regulations have been effective.
The old rules allowed former employees to roll over plan loans for 60 days from the point that the employer “offset” the loan. In short, an offset means that the loan amount is taken off the plan’s books as a plan asset, and the loan is essentially forgiven. To be clear, the IRS may still consider the loan as a taxable distribution, but the loan will not have to be repaid to the plan. But here was the problem for many of those with outstanding loans: first, they might not even know when the loan was offset, and by then if would be too late. For example, if the employer offset the loan when the former employee requested a distribution mid-year, the employee may not be aware of the offset until Form 1099-R is sent out at the end of January. By that time the 60-day rollover window is already closed. Second, even if the employee knows about the 60-day rollover rule (from the date of offset), that’s typically a tight time frame to pay off the loan.
How much additional time to repay a QPLO do individuals have?
In the final regulations, the IRS has clarified that an automatic six-month extension applies to the deadline by which a QPLO must be rolled over, provided that
the taxpayer files a timely tax return, and
the taxpayer takes corrective action within the six-month period.
If these requirements are met, taxpayers will normally have until October 15 of the year following the QPLO distribution to roll over that amount.
Example: On June 1, 2022, your client has a $10,000 QPLO amount that is distributed from her plan. The automatic six-month extension applies if she D timely files her tax return (by April 18, 2023), rolls over the QPLO amount, and if necessary, amends her tax return by October 16, 2023, to reflect the rollover.
Even though the QPLO rules now give clients more time to repay most outstanding plan loans, this doesn’t mean that they will take advantage of this opportunity. In the example above, $10,000 is still a lot a money to come up with for most people, even with the additional time. But it’s also possible to repay a portion of the loan, which then keeps assets in a retirement plan, plus avoids current-year taxation on the repaid amount.
How does my client know whether she has a QPLO, and how are repayments reported?
When your client gets her Form 1099-R at the beginning of the year, Box 7 will show a code “M” for a QPLO versus a code “L” for a loan that is “deemed” to be a distribution (and that is not eligible for rollover treatment). If she repays all or a portion of the loan to an IRA by the deadline, no tax will be owned on that amount; any QPLO amount that is not timely repaid will be included in taxable income for the year in which the QPLO was distributed.
Although QPLOs are considered eligible rollover distributions, financial organizations do not report them as rollovers in Box 2 of IRS Form 5498. Instead, the Instructions for Forms 1099-R and 5498 state that QPLO rollover amounts should be reported in Box 13a. Postponed/late Contrib.; Box 13b. Year should be left blank; and the Box 13c. Code should be “PO.”
Anything else I should know about QPLOs?
There are lots of details in the QPLO regulations that we haven’t covered here. But the basics are pretty straightforward. As with any other decision that your clients make that have tax implications, they should seek competent advice before committing to a course of action.
