The situation involved in Private Letter Ruling 201407027 illustrates that a participant can be caught between a rock and hard place when a qualified plan loan must be repaid upon termination of employment.
Administering qualified plan loan repayments following a participant’s termination of employment can be burdensome for employers. 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. Some plan recordkeepers provide post-termination loan administration services, but since loan administration errors can be costly and time-consuming to fix, employers tend to prefer requiring repayment upon termination of employment.
A plan loan which satisfies all the requirements under Section 72(p) of the Internal Revenue Code does not cause a taxable event at the time the loan proceeds are distributed from the plan. In addition, if loan repayments are remitted in accordance with the loan terms and the requirements of Code Section 72(p), no taxable event occurs during the term of the loan. However, 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. A deemed distribution of a plan loan is not eligible for rollover. Therefore, when a participant defaults on a loan during employment, she has a deemed distribution which is taxable, but the amount of the deemed distribution is not eligible for rollover.
However, under Treasury Regulation Section 1.402(c)-2 Q&A-9, 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.
Confusing? We think so too. If a participant is not able financially to repay a plan loan on 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. That’s good news for this taxpayer, but it still leaves many participants caught in a tough spot when they terminate employment with an outstanding plan loan.