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Qualified plan loans and Coronavirus-related distributions

If a qualified plan participant defaults on a plan loan, can he/she treat the distribution as a Coronavirus-Related Distribution (CRD), even if the plan does not offer CRDs?”  

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Arizona is representative of a common inquiry related to CRDs.

Answer:  Potentially, if there is a loan offset.  If a retirement plan reduces, or offsets, a participant’s account balance by the unpaid portion of a defaulted loan, the IRS considers such amount an actual distribution, which could be treated as a CRD, provided the plan participant otherwise meets the definition of a CRD-qualified individual. (See definition below). A recipient of a CRD can take advantage of special tax rules that allow him/her to pay back the amount within three years (2020, 2021 and 2022); and/or spread the taxation of any amounts retained over three years. Loans treated as “deemed distributions” may not qualify as CRDs (Notice 2020-50).

When a participant fails to meet the repayment requirements of a plan loan and cannot payoff the loan in full, the loan is in default. The plan administrator must handle the outstanding loan balance in one of two ways: 1) as a loan offset or 2) as a deemed distribution.

Loan offset

A loan offset occurs when, in conjunction with the loan default, a participant has a distribution triggering event under the terms of the plan. In this case, the plan administrator will use the participant’s remaining account balance to pay off (offset) the loan amount. The plan reports the offset on IRS Form 1099-R; coded as an actual distribution based on the age of the recipient, and uses special code M to signify “loan offset.”

The IRS considers a loan offset as an eligible rollover distribution, assuming the recipient can come up with the amount out of pocket to complete the rollover in a timely manner. Further, if the plan loan offset is due to plan termination or severance from employment, instead of the usual 60-day rollover period, the individual has until the due date, including extensions, for filing his/her Federal income tax return to complete the rollover. IRS Notice 2020-50 confirms that an offset of a qualified individual’s plan account balance in order to repay a plan loan is permitted to be treated as a CRD, if the recipient is otherwise eligible, regardless of whether the plan allows for CRDs.

EXAMPLE

As a result of a workforce reduction, Cameron was let go from his employer. He has an outstanding 401(k) plan loan which he cannot pay back at this point. Since Cameron has a distribution trigger (i.e., separation from service) the plan administrator will offset his account balance by the outstanding loan amount, and report the distribution on Form 1099-R using code M. Cameron is CRD-eligible, but his 401(k) plan does not allow CRDs. Nonetheless, the IRS allows Cameron to treat the loan offset as a CRD, and take advantage of the special three-year tax treatment rules.

Loan as deemed distribution

In contrast, a deemed distribution of a loan balance occurs when a participant does not have a distribution triggering event under the terms of the plan at the time of the loan default, and no other way to pay back the loan. In this situation, the plan reports the loan amount as distributed using a special code “L” for deemed distribution on Form 1099-R. The participant must include the deemed distribution in taxable income for the year; subject to an early distribution penalty tax (unless an exception applies). A deemed distribution cannot be treated as a CRD, and is not eligible for rollover.

Who qualifies for a CRD?

The definition of a CRD-qualified individual was updated as a result of IRS Notice 2020-50 to include

1)   An individual, his or her spouse, beneficiary or a dependent who is officially diagnosed with COVID– 19;

2)   An individual, his or her spouse, beneficiary or member of the household (i.e., someone who shares the individual’s principal residence) who experiences adverse financial consequences as a result of Covid-19 because of

  • Furlough,
  • Lay off,
  • Job offer rescission;
  • Start date delay;
  • Reduced work hours or pay (including self-employment income);
  • Lack of child care, or
  • A closure or reduction in the hours of a business owned or operated by the individual.

Conclusion

Pursuant to Notice 2020-50, CRD-qualified individuals who experience a loan offset may treat such amounts as CRDs, regardless of whether the plan offers CRDs. Deemed distributions of defaulted loans, in contrast, may not be treated as CRDs, and are not eligible for rollover.

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