Sometimes a participant can be caught between a rock and a hard place when a qualified plan loan must be repaid upon termination of employment. A recent IRS private letter ruling provides a good illustration, notes a Bryan Cave analysis.
Most plans provide that a qualified plan loan must be repaid upon termination of employment to avoid a situation in which the employer must arrange for loan repayments other than through payroll deduction. If a loan is defaulted during the term for non-payment or any other reason, the tax rules treat the outstanding loan balance as a deemed distribution, meaning that the entire amount is treated for tax purposes as a distribution. Since a deemed distribution of a plan loan is not eligible for rollover, when a participant defaults on a loan during employment, a taxable deemed distribution has occurred, but the amount of the deemed distribution is not eligible for rollover.
However, when a participant’s account is reduced to repay the loan, this plan loan offset amount is an eligible rollover distribution. If the terms of the plan require that a loan be repaid upon termination of employment or a request for a distribution, a plan loan offset occurs at these times. At that time, a participant may also rollover the amount of the loan offset (by coming up with the plan loan offset amount from other funds and contributing it to the IRA or other employer plan) to keep that amount from being taxable.
If a participant is not able financially to repay a plan loan upon termination of employment, it’s unlikely she is able financially to come up with the funds to contribute the loan offset amount into an IRA or other employer plan. In Private Letter Ruling 201407027, the financial institution providing administrative services for the plan did not inform the participant of the tax consequences of the loan default. Therefore, the IRS granted him a waiver of the 60-day rollover requirement to allow him to rollover the loan offset amount, according to Bryan Cave attorneys Sarah Sise and Chris Rylands. That was good news for the taxpayer in this case, but it still leaves many participants caught in a tough spot when they terminate employment with an outstanding plan loan.
