When you take out a 401(k) loan, you agree to specific payment terms, including the repayment timeline, interest amount, and total monthly payments you’ll make. 401(k) loans must also meet certain parameters under the plan’s terms and conditions, and the Internal Revenue Service’s and Department of Labor’s requirements.
However, there are some scenarios that would result in failure to meet the terms of your loan agreement or when the plan no longer meets the necessary requirements.
Typically, when this happens, the remaining unpaid loan balance will be “deemed distributed.” Here’s when this might occur and what it means for your 401(k) loan.
What does it mean when a loan is deemed distributed?
A loan is deemed distributed when it fails to meet all of the requirements under either terms set by the plan or the requirements set by the IRS and DOL.
While there are multiple instances where a loan may be deemed distributed, the most common include:
When you do not meet the specified repayment schedule due to missed payments, which are not corrected by the end of what’s known as the cure period (90 days for Guideline plans)
The entire loan balance is not repaid by the end of the maximum repayment period
What happens when a loan is deemed distributed?
When a loan is deemed distributed, the remaining balance will be considered a 401(k) distribution for tax purposes. This means you will need to pay income taxes on any pre-tax balance in the year the deemed distribution takes place. Additionally, if you do not qualify for an exemption, you will be subject to a 10% early withdrawal penalty tax on the full remaining balance.
To assist in filing your tax return, you will receive a 1099-R for the year that shows the deemed distribution. You will not be able to rollover this amount to an IRA or eligible retirement plan. Additionally, since you would have already received the loan amount in cash and no additional amount is distributed, no federal or state tax withholding can be applied.
Do I still need to repay my loan after it has been deemed distributed?
Yes. While a deemed distribution is considered a 401(k) distribution for tax purposes, it is not a distribution for other plan purposes. As a result, you are still obligated to repay the loan.
In order for the loan to be considered fully repaid, you need to repay the full amount that was included on the 1099-R. There is no maximum amount of time a deemed distributed loan can remain outstanding.
Can I take another loan if I had a loan that was deemed distributed?
Because Guideline 401(k) plans only allow for 1 outstanding loan at a time, and deemed distributed loans are still considered outstanding loans, you will need to either repay the full amount of the deemed distribution or the loan will need to be offset before you can request another loan from the plan.
What does it mean when a loan is offset?
A loan offset occurs when the remaining loan balance is distributed from the plan when you are otherwise able to take a distribution. A loan offset is a distribution of the remaining loan balance for all plan purposes.
If an offset occurs when the loan is in good standing (no deemed distribution has occurred), the amount is eligible for rollover. After a loan has been offset, you can no longer repay the loan and the loan is not considered outstanding.
A loan offset can occur if you do not repay your full loan balance in two primary scenarios:
You leave the employer sponsoring the 401(k) plan for any reason (at will or due to termination)
Your employer decides to terminate the 401(k) plan
Further information on offset when leaving your employer or due to plan termination can be found here.
Typically, in these scenarios you will have a set timeframe (90 days with Guideline) from the termination date to pay the loan in full before it will be considered a loan offset.
When an offset takes place with a loan in good standing, it will still be a taxable event and a 1099-R will be issued. However, the amount will be eligible for rollover. Since no actual money is being distributed during a plan loan offset, to complete a rollover, you will need to come up with the amount out of pocket. Additionally, you will be rolling over the amount of the loan, not the loan itself. You cannot rollover the loan and continue to make payments following a loan offset.
Another scenario when an offset takes place is when you are (or become) eligible to take a distribution after a loan has been deemed distributed. A loan offset following a deemed distribution can occur at the same time as the deemed distribution or can occur much later. When the loan offset occurs in these instances, there is no taxable event or 1099-R. Additionally, the amount is not eligible for rollover and you cannot repay the loan. Basically, the offset serves to clear the remaining loan balance left by the deemed distribution from the books.
What is a qualified plan loan offset?
A qualified plan loan offset (QPLO) occurs when you have a plan loan in good standing (there has not been a deemed distribution) and the loan has been offset because you either left the employer sponsoring the plan or the plan has terminated. Provided the offset occurs within 1 year of the termination date, you will have a QPLO.
When an offset is a QPLO, you will have a longer timeframe to indirectly rollover the offset amount into an IRA or eligible retirement plan. Instead of the normal 60-day deadline, you will have until your tax return due date (plus any requested extension) to complete the rollover.
Please note that when completing a rollover of a QPLO, you will need to make up the money to repay the offset loan amount out of pocket. You will not have the ability to rollover the loan and continue to make loan payments.
Examples of deemed distributed loans and offsets
Example 1
Graham is 65 years old and has an outstanding loan balance of $10,000 on which payments have not been made for more than 90 days. Because he is beyond his cure period, Graham’s loan will be deemed distributed and a 1099-R will be issued. Because he is eligible to take a distribution since his plan allows for in-service distributions at age 59 ½, the loan amount will be immediately offset.
This means that Graham will no longer be able to repay the loan amount and will not be considered to have an outstanding loan under the plan. Although the offset is occurring at the same time as the deemed distribution, the amount will not be eligible for rollover because of the deemed distribution. Only a single 1099-R will be issued as an offset following a deemed distribution is not a reportable event.
Example 2
Yasmin is 56 years old and has an outstanding loan balance of $10,000 on which payments have not been made for more than 90 days. Because she is beyond her cure period, Yasmin’s loan will be deemed distributed and a 1099-R will be issued. Yasmin is not eligible to take a distribution since her plan does not allow for in-service distributions until age 59 ½. Yasmin will continue to have an outstanding loan unless she repays it. When she reaches age 59 ½, the loan will be offset. This loan offset will not result in a taxable event, no additional 1099-R will be issued, and the amount will not be eligible for rollover. At this time, Yasmin will no longer be able to repay the loan and will not be considered to have an outstanding loan under the plan.
Example 3
Ryan is 28 years old and has an outstanding loan balance of $10,000, which is in good standing when he leaves his employer. Ryan does not repay the loan before the 90 days pass and his loan is, therefore, offset. The offset will result in a 1099-R.
Because the loan offset is due to a termination of service and the offset occurred within a year of his termination date, this offset is a qualified plan loan offset. As a result, Ryan will have until his tax return due date (plus any requested extensions) to complete a rollover of up to $10,000. Because the plan loan offset does not result in any money being actually distributed from the plan, if Ryan wants to avoid taxation he will need to come up with the money out of pocket.