Avoid Unexpected Tax on Retirement Plan Loans

June 23, 2008

Approximately one out of five participants in company retirement plans borrow money from the plans. In fact, if interest rates rise, plan loans become more attractive. You may be able to get a better interest rate deal from your retirement plan (usually one or two points above the prime rate) than from a financial institution. And, of course, the interest paid on the loan goes back into your plan account rather than into the hands of the financial institution.

Drawbacks

But there are drawbacks to retirement plan loans. For example, while your account is accruing interest while the loan is outstanding, it’s losing out on what may have been a higher return had the funds not been loaned out.

There is another drawback that may come as an unpleasant surprise – If you leave your job, the loan must be immediately repaid, even though the normal loan term may still have several years to run. If the loan is not repaid, the plan can reduce the client’s account balance by the amount of the unpaid loan. This is known as a plan loan offset amount and it’s treated as a taxable distribution to you.

Option to Avoid Tax

An IRS ruling illustrates another option available: If you deposit an amount equal to the plan loan offset in an IRA within 60 days of the offset, it’s treated like a rollover of the offset amount. Just as with a regular distribution, the rollover defers the tax otherwise due on the offset amount.

Let’s take a closer look a retirement plan loans and plan loan offsets so you’ll be prepared if you decide to take out of loan from your retirement plan.

Plan Loans

If a participant in a qualified retirement plan receives (directly or indirectly) a loan from the plan, the loan is treated as a taxable distribution unless certain requirements are met [IRC Sec. 72(p)(1)]. A loan is not treated as a distribution if the following three conditions are met:

1. The amount of the loan (when added to the balance of all other loans from the plan) doesn’t exceed the lesser of

$50,000 (reduced by the amount paid on any outstanding loan during the one-year period immediately preceding the making of the new loan), or

the greater of $10,000, or

1/2 the present value of the participant’s non-forfeitable accrued benefit under the plan.

2. The loan is, by its terms, to be repaid within five years (or, in the case of loans to acquire a principal residence, within a “reasonable time).

3. The loan is amortized on a level basis over the loan term and payments are made at least quarterly.

If there is an express or tacit understanding that a loan will not be repaid, then the amount transferred is treated as an actual distribution from the plan, and is not treated as a loan.

If the amount transferred is a bona fide loan but does not meet the requirements outlined above, then the loan is treated as a deemed distribution. The deemed distribution may occur when the loan is made (e.g., the loan exceeds $50,000) or at a later date (e.g., when a required repayment installment is not made).

A deemed distribution cannot be rolled over to an IRA (or another qualified plan).

If a participant makes any cash repayments on a loan that was treated as a deemed distribution, the repayments increase the participant’s tax basis in the plan as if the repayments were after-tax contributions.

Deemed Distributions v. Plan Loan Offsets

A deemed distribution is not the same as a plan loan offset. A deemed distribution is treated as a distribution to the participant only for certain purposes. With a plan loan offset, the amount of the account balance that is offset against the loan is an actual distribution, not a deemed distribution.

A distribution of a plan loan offset amount occurs when, under the terms governing a plan loan, the accrued benefit of the participant or beneficiary is reduced in order to repay the loan (including the enforcement of the plan’s security interest in the accrued benefit). Such an offset may occur in a variety of circumstances. For example, it may occur when the terms governing a loan require that, in the event of the employee’s termination of employment or request for a distribution, the loan be repaid immediately or treated as in default.

As with other actual distributions, plan loan offsets may be subject to the 10% penalty on early distributions and are reported to the participant on Form 1099-R.

Related IRS Ruling

Obviously, paying off a plan loan before a client terminates his or her employment may sometimes be difficult. The IRA rollover option may buy the client some extra time. For example, let’s say that several years ago Mr. X borrowed money from his company retirement plan to make down payment on a new home. Recently, X accepted a job offer from a new employer in another city. He has signed a contract of sale on his old home, but the sale won’t close before his employment with his old employer terminates. So X will not have the cash to pay off the loan. Here is what X can do to avoid tax on the plan loan offset amount”

Mr. X does not pay off the plan loan upon termination of his employment.

The retirement plan declares the loan in default and offsets his account balance by the amount of the loan.

X sets up an IRA at Bank A.

X instructs the plan to issue a check for the net account balance, made payable to Bank A as trustee for his IRA.

X closes the sale of his home and, from the proceeds, writes out a personal check to Bank A in an amount equal to the plan loan offset amount.

Within 60 days of the declaration of default, X deposits both checks in the IRA set up at Bank A.

On facts similar to these, the IRS has ruled that a taxpayer owed no tax [PLR 200617037]. The IRS pointed out that its regulations provide that a plan loan offset amount (unlike a deemed distribution) can qualify as an eligible rollover distribution. Thus, an amount equal to the offset amount can be rolled over tax-free to an IRA (or another qualified retirement plan) within the required 60-day period.

Withholding Tax

Eligible rollover distributions, including a plan loan offset amount, that are not rolled directly over into an IRA (or another qualified plan) are generally subject to a mandatory 20% withholding tax. However, although offset amounts must be included in the withholding tax base, the total amount required to be withheld is limited to the sum of the cash and the fair market value of property (other than employer securities) received by the plan participant.

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