Posted By Tyler Starr, CPA
The Tax Cuts and Jobs Act (Tax Act) resulted in major changes to the US income tax code. There is a still a debate about the effects these changes will have on individuals and whether the positives outweigh the negatives. One welcomed change affecting the employee benefit plan world is the extension of the time period a participant has to pay the amount offset for a defaulted participant loan to another qualifying plan or IRA to accomplish a tax-free rollover of the otherwise taxable distribution of a loan offset amount. The change became effective January 1, 2018, and will apply to loan amounts that are treated as distributed in tax years beginning after December 31, 2017.
Why borrow from your 401(k) account in the first place?
You likely can’t stop financial hardships from happening. No matter how prepared you are, life will throw curveballs at you, and usually it will throw more than one at a time. Maybe you have severe damages to your home, emergency medical situations, tuition due, or just need to pay down debt that has been piling up. If you have a 401(k) plan with your employer, and the plan offers loans, you can withdraw a portion of your retirement savings account to help with your financial need. 401(k) loans are generally much easier to qualify for than a hardship withdrawal, which can only be taken for specific reasons, and can be obtained from your plan quickly with only a small administration fee. 401(k) loans typically offer reasonable interest rates that you pay back into your own account, rather than to a creditor. The big advantage over an in-service distribution, such as a hardship distribution, is that 401(k) loan withdrawals, if repaid timely, are not taxable.
What happens if you separate from your employer with an outstanding loan?
We just stated that 401(k) loan withdrawals are not taxable. The key word in the sentence above is timely. If you’re terminated from employment, you no longer have as much time to repay the loan. Prior to the Tax Act, participants had 60 days to roll over a plan loan offset amount to an eligible retirement plan that accepts rollovers. A plan loan offset is the portion of a participant’s account balance that must be reduced in order to repay the outstanding portion of the loan. The unpaid balance would be treated as a taxable distribution after 60 days, plus would be subject to the 10% penalty if the participant is under 59½. If you find yourself in the middle of a layoff or getting fired, you could end up owing a large amount of tax at the end of the year, without the funds to pay it. If you’ve recently terminated employment unwillingly, dealing with your 401(k) account is likely not the first thing on your mind. You’re probably more concerned with finding a new job and making sure your bills are paid. By the time you remember you had a 401(k) loan, the 60 days have already passed and you’ve been hit by another one of those curveballs we we mentioned earlier.
Changes under the new rule
The new rule discussed above may help you avoid that large tax bill. Under the new Tax Act, the 60-day period was extended to the filing due date for the participant’s tax return for the year in which the loan offset amount arises. This means the deadline for any offset that arises during the tax year will not be until April 15 of the following year, which can be extended to October 15 with a tax return extension. Participants now have a much larger window of time to come up with the funds to deposit the offset into an IRA or another qualified plan to avoid taxation.
Remember, this extension of time is only available for loan offsets that become taxable due to separation from employment. This extension is not available for participants that defaulted on a loan repayment while still employed. For participants to receive a benefit from this change, they will have to be aware of the tax consequences of loan offsets. Most participants in this situation don’t realize that they have the right to roll over their funds and as a result, they get hit by that curveball in January when they get a 1099-R in the mail long after the 60-day deadline has passed. Under the new law, the participant could have anywhere between 4½ to 22½ months to deal with their loan offset. This additional time is likely needed, as in most cases the participant would not have the resources available to fund the rollover if they had to take a 401(k) loan in the first place and now, to make matters worse, they are out of a job. Curveballs are a normal part of life, but with the right planning and solutions you can do your best to recover and move forward.