While work retirement plans (e.g., 401k, 403b, and 457b) are not required to allow for participant loans, the majority of them now do.
Many solo 401k plans and ROBS 401k plans get funded with former employer plan funds which may contain outstanding participant loans. Often times, the individual is not aware the outstanding participant loan balance can be indirectly rolled over (“loan offset” discussed below) to an IRA or a 401k plan if he or she is unable to pay the outstanding loan in full prior to requesting the transfer-out of the the former employer plan funds.
General Participant Loan Information
- Generally, participant plan loans are limited to 50% of the participant’s account balance, but no more than $50,000.
- The participant loan is generally paid back over a 5 year period in level payments and on a quarterly basis.
- The loan period is extended to 15 or 30 years if the borrowed proceeds are used toward the purchase of the participant’s primary residence.
What is a Participant Loan Offset?
When you leave your employer (separate from service) but do not pay your outstanding participant loan balance, the outstanding loan balance may be offset by the remaining funds in your participant account in order to payoff the loan.
The loan offset will be considered an “actual distribution” even though the participant does not receive any actual funds. Thus, federal taxes and the 10% early distribution may apply if you are under age 59 1/2 unless you rollover the “offset amount” to an IRA or another qualified plan such as a solo 401k plan by the deadline described below.
The Deadline to Rollover the Participant Loan Offset Amount
In order to avoid having to pay taxes and penalties on the outstanding participant loan balance at time of separation from the employer, the loan offset amount (the outstanding loan balance) has to be rolled over to an IRA or another qualified plan such as a solo 401k plan by the participant’s Form 1040 tax return (personal tax return) due date plus extension, so by October 15. Note that you are not required to file a personal tax return extension.
John leaves his Boeing employer on July 15, 2020 and has $80,000 in his 401k as well as a $20,000 outstanding 401k participant loan balance.
John can’t come up with the $20,000 to repay his 401k participant loan. He then submits transfer instructions to have the $80,000 directly rolled over / transferred to his self-employed solo 401k plan. The administrator of the former employer 401k plan proceeds by first offsetting the $80,000 plan balance by the $20,000 outstanding participant loan balance, resulting in transferring $60,000 to John’s solo 401k plan.
While John does not receive the $20,000, he can roll this amount to the solo 401k plan or an IRA if he can come with this amount with funds from his personal bank account, for example, by October 15, 2021.
On the other hand, if John is not able return the $20,000 to his solo 401k or IRA by the October 15, 2021 deadline, he will owe income tax and a 10% early distribution penalty if he was under age 59 1/2 at the time of the distribution, with the taxes and penalty due by the October 15, 2021 personal tax return deadline since the distribution would be considered as occurring in 2020.
What is a Deemed Distribution?
A deemed distribution occurs when the participant violates the terms of the 401k participant loan (e.g., loan amount, the loan term, and the repayment schedule). The deemed distribution amount is the outstanding loan balance. In the above John example, if John had defaulted on his $20,000 401k participant loan prior to electing to terminate his 401k plan through Boeing, the outstanding loan balance will be deemed a distribution subjecting John to taxes on the outstanding loan amount and a 10% penalty if he was under age 59 1/2 at the time of the loan default. Lastly, a deemed distribution is not eligible for rollover to an IRA or another qualified plan such a a solo 401k plan.