While a 401(k) plan loan can often provide an option for obtaining otherwise unavailable financing, the rules governing these loans are specific and failure to follow them can, in some circumstances, result in a surprise tax bill.
Importantly, the loan must be repaid within certain time frames to avoid treatment as a deemed distribution (which would be fully taxable). In cases where a plan participant takes a loan and is subsequently fired, this result can easily lead to a tax-free loan becoming an entirely taxable distribution. Fortunately, the 2017 tax reform legislation has eased the burden on taxpayers in certain specific situations—and understanding these new rules can become key to avoiding the surprise liability of a taxable 401(k) loan.
The Tax-Free 401(k) Loan
A 401(k) plan is not required to provide for plan loans—and even if the plan does, the value of the loan cannot exceed (1) the greater of $10,000 or 50% of the account balance or (2) $50,000, whichever is less. While 401(k) loans generally have a bad reputation, for a financially responsible client who has a short-term need for additional funds, a 401(k) loan can provide an appealing option. Generally, the loan balance must be repaid within five years and payments must be made at least quarterly (special rules apply in the case of a 401(k) loan taken out to finance the client’s principal residence).
However, if the client leaves his job (or is fired), the loan must be repaid within 60 days in order to avoid taxes and penalties (the 10 percent excise tax for early distributions will apply in addition to ordinary income taxes if the client is under 59 ½). Typically, the client would roll the required funds into another tax-preferred retirement account within the 60-day period to avoid taxes and penalties.
This is known as a “plan loan offset” (or the part of the taxpayer’s remaining 401(k) account balance that would have to be reduced in order to repay the loan). Prior to tax reform, the client had only 60 days to come up with the funds necessary to satisfy this requirement, which could, in many cases, present a problem for a client who may have recently lost his or her primary source of income. The otherwise applicable five-year time frame does not apply to clients in this situation.
These rules applied for any qualified plan, including 403(b) and 457 plans as well as 401(k)s.
Tax Reform Changes
Under the 2017 tax reform legislation, the 60-day deadline is extended to the participant’s tax filing deadline for the tax year in which the offset occurs if the amount is treated as distributed from the participant’s qualified 401(k) plan because either: (1) the plan was terminated, or (2) the participant failed to meet the loan repayment terms because of a separation from employment (if the plan provides that the accrued unpaid loan amount must be offset at this time).
This generally means that clients will have until April 15 of the following tax year (or October 15 if they take advantage of the ability to extend the deadline) to gather the funds necessary to satisfy the offset.
This extended time period does not apply to loans that have already been deemed taxable distributions (whether because the loan installment payment remained unpaid beyond the applicable cure period or because the loan’s terms did not comply with the IRC requirements). If the default occurred while the individual remained employed with the employer and continued to have the ability to participate in the plan, the 60-day limit continues to apply.
The new extended timeframe for repaying 401(k) plan loans in certain circumstances can prove particularly helpful for clients who have lost their jobs—however, it is, as always, important to understand the limitations of tax reform’s rule to avoid surprises at tax time.