Effective January 1 of this year was the right of participants to an extended period to rollover their defaulted loan amount, if the default arose following unemployment or the termination of a plan. The statue has a fundamental flaw: it confuses the rules related to the taxation of the loan with the distribution rules related to defaulted loans. The practical effect of this confusion is that it is virtually impossible to effectively use. Making it work requires the acceleration of the reduction of the plan’s retirement benefit, which runs counter to the fiduciary obligations under a loan program.
It may be helpful first to discuss how the defaulted loan rules actually work, and then to see how the statute doesn’t.
There are two types of distributions related to defaulted loans: “deemed” distributions and “actual” distributions. A “deemed” distribution occurs when there have been insufficient loan repayments made in the quarter, or through the “cure period” (the following quarter) to meet the amortization requirements. When this happens, the loan is a “deemed distribution,” and will be reported as taxable even if the participant’s account balance was never offset by that amount. The regulations specifically state that a “deemed” distribution will NOT be treated as an “actual” distribution.
An “actual” distribution of a loan default occurs “when, under the terms governing a plan loan, the accrued benefit of the participant or beneficiary is reduced (offset) in order to repay the loan (including the enforcement of the plan’s security interest in the accrued benefit). A distribution of a plan loan offset amount could occur in a variety of circumstances, such as where the terms governing the plan loan require that, in the event of the participant’s request for a distribution, a loan be repaid immediately or treated as in default.” (1.72(p) Q&A 13(a)(2)).
An “actual” distribution also generally can’t occur unless there has been a distributable event under a 401(k) or 403(b) plan, which can further complicate things. Particularly in the 403(b) space where non-payroll deduction loans are common, loan offsets may not occur for a number of years after the “deemed default.”
There is no uniform practice to offsetting account balances upon loan default. Often, they are not offset until the participant comes in for a distribution after terminating employment, or under some sort of periodic “sweep” performed by the recordkeeper. In any event, there is not typically an independent notice to the participant of the date of the offset.
There is also growing practice to preserve the account balance, and to avoid the offset of the account balance. As part of the fiduciary obligation to protect a retirement benefit, more employers are permitting terminated employees to continue to make post-severance payments on their own. According to the 2017 PLAN SPONSOR Defined Contribution Survey, 26.2% of DC plan sponsors that responded to the survey said this feature has been or will be added to their plans, and an additional 5% are considering adding the feature in the future. These efforts requires employers to delay the actual offset following the default. Adding an insurance feature to protect the loans also requires a delay in the offset.
By the way, the rules do not require the offset upon default. In fact, the preamble to the DOL regs actually encourage delaying the offset in order to enable employers to find a different way to repay the loan. Offsets of a retirement benefit should be the last resort under the fiduciary rules, not the first.
Add to this the fact is participants really will not know whether there is an offset unless they know to look at their next quarterly statement -and know what to look for. There is no independent notice of the offset.
So, what does all of this mean? In reality, a substantial number of loan defaults will result in taxation under the “deemed” distribution rules, rather than the “actual” distribution rules, and can’t be rolled over until the offset actually occurs. Which means the rollover extension rules get applied in an odd sort of way, ending up in some curious mismatches.
Let’s use an example. Assume a participant/borrower is laid off from employment in June 1, 2018; the loan defaults because the layoff resulted in no payroll deductions being made; the employee does not take advantage of the post-separation repayment program offered by the employer; and the account balance is not immediately offset because of the necessity of delay caused by the post separation loan program. That loan becomes taxable as a deemed distribution at the end of the cure period, September 30. The participant could NOT roll over the amount of that loan because no offset has occurred. Assuming no offset has occurred by year end, the defaulted loan amount with penalties (if applicable) will be reported on the Form 1040.
Assume further that the participant, still unemployed by the plan sponsor, takes a distribution on January 1, 2019, and the recordkeeper then offsets the account balance. Now what? The tax liability has fixed in the prior tax year. Though the participant has the right now to roll over that amount to an IRA by April 15, 2020 (or the extended due date), this right is meaningless because the tax liability has already attached, and it would be an after-tax amount.
The new rule really doesn’t work well at all unless there is a massive movement to immediately offset retirement accounts-which has horrible public policy ramifications. Forcing increased leakage into the system to make the promise of an extended rollover period work seriously undermines the efforts underway to preserve these at-risk assets. Accelerating offsets is counter to the fiduciary’s obligation to preserve the retirement benefit under the plan.